While finding a good deal on a GREAT commercial property is one way to make money in commercial real estate, the ability to discover profit potential by seeing what other buyers and developers have not is the mark of the true CRE expert.
All investors are interested in getting the greatest possible return for their capital, but most limit themselves to tactics designed to make the most out of a property as it’s presently being used. Increasing usable square footage of a shopping area’s underground garage by renting it out to non-customers, or turning a basement into rentable storage areas are some common examples.
The CRE visionary, however, takes the principal of highest and best use to the tenth power by envisioning a completely new and unexpected use for an income property. They are the reason some parking lots remain deserted, weed-filled eye-sores while others are transformed into high-rise condominiums.
You might think that these types of visionary investors are either lucky, or uber-talented whiz kids who were already analyzing the markets at the tender age of eleven.
In reality, learning how to think out of the box in commercial real estate is a skill that can be learned, and the first step in learning how to think creatively is to use highest and best use (HBU) to analyze potential properties.
Use These 4 Highest And Best Use Critetia To Find Hidden Profit Opportunities
There are 4 criteria that are used to decide on HBU, and we’ll discuss each one below.
PHYSICAL POSSIBILITY
In this criteria, you’ll want to determine what is physically possible with the property.
One way to do that is by brainstorming numerous potential uses for the property, without considering whether or not each one is actually possible. This is where a detailed knowledge of the area pays off. By looking at the surrounding area, you should be able to get an idea of what type of commercial properties might be needed.
For example, is housing in great demand? By whom? According to a recent report, work-live-play communities neighborhoods perform better commercially, economically, and had lower capitalization rates during the recent recession than their suburban counterparts.
A careful analysis of the demographics and growth patterns of the area would help determine whether or not this is a feasible option. In considering what is physically possible, don’t forget to consider things below ground as well. Issues like terrain and drainage, as well as sewer capacity, can play a critical role in the success of your project.
LEGALLY PERMISSIBLE
Determining what is legally permissible requires a thorough analysis of both public and private restrictions. You’ll need a lawyer who specializes in this area, since it’s fairly complicated, and a simple misunderstanding of the laws could cause irreplaceable losses.
Your lawyer will investigate:
- current zoning and land use restrictions,
- private restrictions,
- building codes,
- and resident and city council objections…
As well as the likelihood of changing any of the above restrictions in order to get your project APPROVED.
PHYSICALLY POSSIBLE, LEGALLY PERMISSIBLE AND FINANCIALLY FEASIBLE
Once you’ve determined what uses are both physically possible and legally permissible, it’s time to look at whether they are also financially feasible. In other words, can any of these uses be expected to return a net profit for you as an investor?
An appraiser will evaluate the property as if it is both vacant and improved. This is to help determine whether or not the property fits into one of 4 categories:
- The present site is being used at its highest and best use
- The present use of the site is an under improvement: in other words, the property is not being used at its highest and best use, but doesn’t necessitate demolition since it is still contributing to the value of the land (common in older commercial property)
- The present use of the site represents an overuse of the site. This is usually due to changes in zoning or other land-use controls that have limited the the types of uses allowed.
- The site is NOT being used at its highest and best use; furthermore, the existing improvements should be DEMOLISHED in order to improve site use.
If it is determined that the site is under-improved, and requires demolition or improvement so that it can be used for its highest and best use, then the step below comes into play.
FINANCIALLY FEASIBLE AND PROFITABLE
Once it’s been determined what the potential highest and best use of a site is, the next step is to determine whether or not that step is not only financially feasible, but PROFITABLE as well. Commercial investors expect to see a return on their investment, not just for the short-term, but for the long-term as well.
Savvy investors will take all of these factors in mind when making their decision – but will add one very important consideration: the expectation of risk and reward for the project.
Based on your investment goals and the present state of your investment portfolio, your tolerance of risk and expectation of reward will differ from other investors. Thus, its important to remember that regardless of what the HBU is for a site, if the resultant recommendations don’t fit in with your investment plans, then it would be wise to invest your funds elsewhere.
Do you have any examples of sites or properties that were converted to a HBU, and were profitable? Join the conversation over at Google +.
