Highest and Best Use and Value Principles

Chapter 2: Highest and Best Use and Value Principles

V. Effect of Use on Real Estate Value

A. HIGHEST AND BEST USE PRINCIPLE

The principle of highest and best use is crucial to valuing real estate. The HIGHEST AND BEST USE principle states that the value of property is determined by the most profitable use to which the property may reasonably (and legally) be put. Thus, to determine market value for a property, the appraiser must first analyze its highest and best use. This principle is fundamental to real estate appraisal and decision-making, driving investment and development strategies. It is a cornerstone of economic land use theory. The concept of highest and best use is based on four tests that the use must meet:

1. Legally Permissible: The use must be allowed under applicable zoning regulations and other legal restrictions. This includes considering potential variances or zoning changes. The legality assessment considers the current zoning ordinances, building codes, environmental regulations, and any private restrictions (e.g., deed restrictions).

2. physically possible❓❓: The site must be physically suited to the use. This involves considering factors such as size, shape, topography, soil conditions, accessibility, and environmental constraints. Geotechnical studies and environmental assessments often contribute to this analysis. For example, a site with severe soil instability might not be physically possible for high-rise construction without significant remediation.

3. Financially Feasible: The use must generate sufficient revenue to cover all operating expenses, debt service, and provide a reasonable return on investment. This requires a thorough financial analysis, including market studies, cost estimates, and income projections. The financial feasibility analysis considers the cost of development, potential revenue, operating expenses, financing costs, and a reasonable rate of return for the investor. This is often evaluated using discounted cash flow analysis or other investment metrics.

4. Maximally Productive: Among all uses that are legally permissible, physically possible, and financially feasible, the highest and best use is the one that results in the highest value for the property. This requires comparing the potential returns from different uses and selecting the one that maximizes net present value.

Mathematical Framework:

Let:
V = Value of the property
U = Possible use of the property
L = Legally permissible uses
P = Physically possible uses
F = Financially feasible uses
MP = Maximally Productive

The Highest and Best Use (HBU) can be formally expressed as:

HBU = arg max {V(U) | U ∈ L ∩ P ∩ F}

This equation means that the highest and best use is the use (U) that maximizes the value (V) of the property, subject to the constraints that the use must be legally permissible (L), physically possible (P), and financially feasible (F).

Practical Applications:

• Zoning Analysis: Understanding local zoning ordinances is critical. A property zoned for single-family residential use cannot be valued as a commercial property unless a zoning change is likely.
• Market Studies: Conducting market studies to understand demand for different types of uses. This provides the basis for financial feasibility analysis.
• Cost-Benefit Analysis: Evaluating the costs and benefits of different development scenarios. This involves projecting revenues, expenses, and potential profits.
• Sensitivity Analysis: Examining how changes in key variables (e.g., rents, vacancy rates, interest rates) affect the feasibility of different uses.

Example: Consider a vacant lot in a growing urban area. The lot is zoned for either a small office building or a multi-family residential complex.

• Legally Permissible: Both uses are allowed under the zoning ordinance.
• Physically Possible: The site is suitable for either type of development.
• Financially Feasible: A market study indicates strong demand for both office space and apartments. However, a financial analysis shows that the multi-family complex is projected to generate a higher net present value due to higher rental rates and lower operating expenses.
• Maximally Productive: Based on the financial analysis, the multi-family complex is the highest and best use because it maximizes the property’s value.

Experiments and Empirical Evidence:

• Regression Analysis: Econometric models can be used to analyze the relationship between land use, property characteristics, and market values. Regression analysis can quantify the impact of different land uses on property values, helping to identify the most productive use. For instance, a regression model might estimate the impact of zoning designations on property values, controlling for other factors such as location, size, and amenities. The model could take the form:

Value = β0 + β1 * ZoningType + β2 * Location + β3 * Size + ε

Where:
Value = Market value of the property
ZoningType = Indicator variable for different zoning designations (e.g., 1 if multi-family, 0 if single-family)
Location = Measures of accessibility or neighborhood quality
Size = Size of the property
β0, β1, β2, β3 = Regression coefficients
ε = Error term

By analyzing the coefficient β1, one can estimate the impact of zoning type on property value, providing empirical evidence to support the highest and best use analysis.

• Land Use Modeling: Simulation models can be used to project the future demand for different types of land uses based on demographic and economic trends. These models can help identify areas where specific types of development are likely to be most profitable.
• Case Studies: Analyzing real-world development projects to understand how developers and investors have applied the highest and best use principle in practice. This involves examining the factors that influenced their decisions and the outcomes of their projects.

When analyzing improved real estate for its highest and best use, the appraiser draws a distinction between the actual highest and best use, and the highest and best use that would apply if the property were vacant (i.e., unimproved). The fact that the highest and best use of the property, if vacant, would be something other than the current use does not necessarily mean that the property’s current use is not its highest and best use. That would only be the case if the value of the land in a vacant state (for some other use) exceeded its value as currently developed. The cost of demolition and site preparation plays a crucial role in this determination.

B. Consistent Use Principle❓❓

The principle of consistent use relates to the appraisal of improved property. CONSISTENT USE requires both the land and the improvements to be valued for the same use, even if they are being valued separately. It is improper to value the land for one use and the improvements for a different use. This principle ensures that the valuation reflects a coherent and realistic scenario. It prevents artificial inflation of value by considering incompatible uses for the land and improvements.

Example: A property with a retail store cannot be valued by valuing the land as if it were vacant and suitable for a high-rise apartment building, while valuing the existing retail store based on its current income. Both the land and improvements must be valued for the same use, either retail or apartment.

C. CONFORMITY, progression❓❓, AND REGRESSION PRINCIPLES

According to the PRINCIPLE OF CONFORMITY, property values are enhanced when the uses of surrounding properties conform to the use of the subject property. This is the rationale behind zoning regulations, which seek to group compatible uses together and to separate incompatible uses. A higher degree of homogeneity in land use leads to increased stability and predictability in the property market. This principle aligns with the concept of positive externalities, where the benefits of nearby properties spill over to the subject property.

In practice, the principle of conformity is influenced by local perceptions of the kind of conformity that is desirable. Variation in architectural styles, for example, may be viewed favorably in one context, and unfavorably in another. A mix of commercial and residential uses in an urban setting could have a positive effect on values, where the same mix of uses in a suburban setting could have a negative effect. In applying the principle of conformity, the appraiser needs a sound appreciation for local customs and standards.

Progression and regression are terms used to describe the effect on value when a property does not conform to the level of improvement of surrounding properties. When a property that is much more luxurious than surrounding properties suffers a decline in value, it is called REGRESSION. By the same token, a modest home in an area of more expensive houses would see a relative increase in value called PROGRESSION. These effects demonstrate the importance of context in real estate valuation.

Mathematical Representation:

Let:

V(p) = Value of property p
C(p) = Conformity index of property p (measures the degree of conformity with surrounding properties)
N(p) = Neighborhood characteristics of property p

We can model the value of a property as a function of its conformity index and neighborhood characteristics:

V(p) = f(C(p), N(p))

The function f(C(p), N(p)) would typically show a positive relationship between conformity and value up to a certain point, reflecting the benefits of conformity. However, the relationship could become negative if the property is too different from its surroundings, resulting in regression.

VI. Production as a Measure of Value

In economic theory, PRODUCTION refers to the creation of wealth. Production is the ability to create wealth that can be converted into value. This is particularly relevant in real estate, where development and renovation activities directly create value. The cost of production serves as a lower bound for the value of a property. If the cost to reproduce or replace a property exceeds its market value, there is likely an oversupply in the market or other factors depressing prices.