How Understanding Highest and Best Use Can Lead to Better Returns in Commercial Property
Optimizing the Highest and Best Use in Commercial Real Estate
When it comes to commercial real estate investing, determining the highest and best use is crucial. This refers to the utilization that maximizes risk-adjusted returns for all stakeholders involved with the asset.
What Does the Principle of Highest and Best Use Entail?
In the realm of commercial real estate appraisal and valuation, the highest and best use of a property refers to the utilization that will yield the utmost value to stakeholders. When appraising a property's highest and best use, it is crucial for the appraiser to evaluate not only its current use but also explore potential alternative uses.
In the context of commercial real estate investment, the highest and best use typically denotes the utilization that provides the greatest risk-adjusted returns. However, appraisers may also take into account other factors such as community development goals and specific advantages for potential owners, particularly in the case of owner-occupied real estate.
The Four Tests for Determining the Optimal and Most Valuable Use
When considering the highest and best use (HBU) of a property, four tests must be met for potential use to qualify as appropriate. It must be physically viable, legally permissible, financially feasible, and maximally productive.
Physically Achievable
For a property to be optimally utilized, its size, shape, and condition must align with its highest and best use. Consider, for instance, an office building with a 20,000 sq. ft. footprint - it would clearly not be suitable for a 10,000 sq. ft. site. Similarly, constructing a building with a large basement or below-ground area in an area with a high water table (such as South Florida) would be impractical.
Permitted by Law
In general, this test pertains to zoning and building regulations, which commonly impose restrictions on property size, footprint, and usage. Appraisers typically possess a profound understanding of the zoning rules in their practice area, and this information is readily accessible.
Additionally, this test may encompass environmental laws and regulations, aimed at ensuring that buildings do not have a detrimental impact on the surrounding environment. For larger projects with substantial profit potential, developers may consider seeking a zoning exception, also known as a variance, from the appropriate city or municipal authority.
However, to achieve success, they typically need to demonstrate that the project will contribute significantly to economic development or provide other benefits to the community in proximity.
Financially Viable
To assess the financial viability of a proposed property use, an appraiser examines it as if it already exists, creating pro forma financial statements. This involves conducting a comprehensive market analysis, estimating development and construction expenses, OpEx, potential cap rates, and vacancy rates, and considering various other factors.
With this information, an appraiser can determine the estimated internal rate of return (IRR), allowing potential developers or investors to evaluate if it meets their return requirements. Additionally, using discounted cash flow analysis, the appraiser can calculate the net present value (NPV) of the property based on a specific required return. If the NPV is above zero, it indicates that the property exceeds the required return.
Key Takeaways
The principle of highest and best use refers to utilizing a property in a way that maximizes its value for stakeholders. When appraising a property, evaluators must consider potential alternative uses to determine its highest and best use. Moreover, keeping yourself updated on current commercial mortgage rates is crucial for making well-informed decisions about loan options.
Typically, the highest and best use of a property yields the highest risk-adjusted returns. To qualify as the highest and best use, a proposed use must pass four tests: physical feasibility, legal permissibility, financial feasibility, and maximum productivity. It's also essential to secure the best financing terms.
You can conveniently apply through Janover to explore your options. While appraisers may not calculate it, developers can assess a project's potential equity multiple over a specific time horizon, both with and without debt. Additionally, developers may consider the estimated residual land value of a property after potential improvements in certain cases.
Achieve Maximum Productivity
Once a property has been thoroughly evaluated in terms of its legal compliance, physical feasibility, and financial viability, an appraiser will assess its potential uses. These possibilities are then ranked based on the adjusted returns considering the associated risks. It is not uncommon for the options with the highest potential returns to be deemed too risky for investors. Consequently, appraisers often apply a discount rate based on risk to adjust the property's internal rate of return (IRR).
The Four Categories of Highest and Best Use
Once a property has been thoroughly assessed using the four aforementioned tests, the appraiser can then identify the appropriate category from the four general Highest and Best Use (HBU) classifications. These categories encompass:
Highest and Best Use: The property is currently maximizing its value for owners/investors, and potentially benefiting the surrounding community as well. No significant improvements can be made to enhance its value further.
Under improvement: Although the property may not be currently maximizing its potential, it still offers investors a reasonable return. Demolishing the property would unlikely yield a worthwhile return on investment. However, given the circumstances, a renovation or expansion could potentially provide a more favorable outcome.
Zoning Violations: The property currently fails to comply with zoning or building regulations. For instance, it may exceed height restrictions in an area that only allows buildings of a certain height. Structures might encroach upon property lines, or commercial property may be located in a strictly residentially zoned area.
If the building violates new zoning regulations implemented after its construction, it may be considered 'grandfathered in.' Otherwise, the owner may need to pay a fee or modify the building to adhere to municipal standards.Non-Optimal Use: The property is evidently not being utilized to its maximum potential. For instance, consider a property with a spacious, two-story apartment building located in a high-demand area that allows for 20-story condominiums. The existing land improvements should be cleared to pave the way for new development.
In conclusion, achieving the highest and best use of a property requires a deep understanding of various factors and adherence to key principles and tests. This process can be complex and challenging.
Fortunately, our team at Kirby & Kirby is here to guide you through every step, ensuring you optimize your returns on commercial property investments. Don't leave your investment to chance; reach out to Kirby & Kirby today to discuss your property's potential.
