Highest and best use analysis in commercial real estate allows investors to add value to a potential property through improving vacant land or a property.
Thus, determining the highest and best use of a property will help an investor find the most profitable use.
With any property, there are three possibilities for determining highest and best use:
- Tearing the property down and building another property on the same site
- Changing the present use
- Leaving it the same
There are four factors appraisers use when determining the feasibility of improving a property: legal permissibility, physical possibility, financial possibility, and maximum productivity.
1. Legal Permissibility
Before considering how vacant land or property can be improved to increase its value, investors need to consider whether or not changes can legally be made. Building codes, historic district rules, zoning laws, and environmental regulations may prevent even the smallest of changes on a property.
In the case of zoning restrictions, investors should consider which uses are currently allowed, and which renovations would require changes in zoning laws to be enacted.
Title and deed restrictions may also present a problem, as may long-term leases, which might contain clauses that prohibit building setbacks, types of materials, or heights.
The other possibility is that certain uses may be permissible, but the cost of construction would be prohibitive due to requirements by historic or local building codes. This would, of course, restrict interest in such a project, and make it less attractive to developers.
Environmental laws requiring developers ensure clean air, water, and ensure the survival of surrounding wetlands may also impact on proposed construction. The local population might also present concerns regarding new developments or construction in the area.
2. Physical Possibility
Physical possibility refers to whether the size, shape, terrain, and accessibility of the property may be improved.
This takes into account natural disasters like hurricanes or earthquakes, as well as whether the size of the parcel is amenable to construction.
For example, if a parcel is shaped irregularly it will cost more to build on it and will be more difficult to fully utilize all portions of the land. It may also impact ease of access. Land that is significantly sloped contains major dips in the land or due to poor topsoil requires grading, will also cost more to develop.
And last, investors should also check whether public utilities are located at or near the parcel, and if so, whether they would be able to handle the additional capacity imposed by the planned project.
3. Financial Feasibility
Financial feasibility is simply whether or not the parcel or property will give higher returns once renovated. In order to estimate future gross income, investors will need to calculate operating expenses, vacancy related expenses, and any other expenses, and then subtract the resulting number from the gross income.
This will give investors an estimated NOI; this number should be calculated for each possible use of the property or parcel being considered.
4. Maximum Productivity
In determining the maximum productivity, appraisers are attempting to determine what use would provide the highest net income.
This usually requires a market study, since while a highest and best use analysis will help determine the value of the property, the market will decide what that use should be.
Thus, a market analysis of the property is essential.
Here are some common questions asked during a market analysis that will help you analyze a property:
- Is the property located in a high traffic area?
- Where is the neighborhood with regards to the growth cycle?
- Is there easy access to the property?
- Is there sufficient parking?
- What businesses are in the same area?
- Are there any new projects planned for the area?
- Are there any restrictions on the building?
- Are there any restrictions on the land surrounding the building?
- What differences are there in zoning restrictions that apply specifically to the sale of the property? To leasing the property?
Building Compliance and Regulations
- Are there any problems with compliance of regulations for the property?
- Are there any risk or liability factors that affect the property?
- Are there any problems with tenants, such as rent owed, or vacancies?
- Examine the lease of each tenant carefully; are there any clauses that can prevent you from renovating the property in a reasonable timeframe?
Supply and Demand
- Is there sufficient demand for that property type in the area?
- Is there high or low supply for that property type in the area?
- How does the building compare to similar ones in the area?
- Is the property considered a modern property, with recent finishes?
- Would tenants want to rent the property as it is presently? If not, how long would it take you to make the necessary upgrades?
Making sure you have all the details is critical to making the right decision for the highest and best use of a potential property. Reviewing the numbers – rather than hoping for a particular outcome, is your best bet for success when it comes to envisioning a new purpose for a commercial property.