Have you ever passed by a parking lot adjacent to newly-built high-rise apartments or mixed-use office buildings and wondered how much money the owner is missing out on?
It’s easy to assume that the properties around a seemingly under-utilized property determine its value. In the case above, for example, it might be tempting to view the parking lot as a lucrative deal waiting to happen.
In fact, while there are several factors involved in determining the value of a particular commercial income property, the highest and best of that property – which means the type of use that provides the highest dollar return for the land- isn’t decided by a broker, property owner. or developer.
In order to decide whether or not that parking lot would do better as an apartment or office building, you would first need to ask yourself these four questions:
Is the most probable use of the land or improved property:
- legally possible?
- physically possible?
- financially feasible?
- most profitable?
Each answer is cumulative, meaning that probable use of the property must be one that is legally possible and physically possible, and financially possible and financially feasible.
It is obtained by comparing the most likely and profitable use of the site (i.e. land) versus the maximize value after improvement obtained by the property, as determined by the NOI. Also, the first two questions are often considered together, while the last two cannot be decided until the first two receive a go-ahead.
Whether or not an improved usage is legally possible depends of course on many factors:
- Zoning laws
- Building code restrictions
- Local government initiatives and
- Neighborhood opposition
These are examples of factors that would need to be taken into consideration.
The situation can get even more complicated if the immediate area or surrounding areas are not strictly zoned for commercial use. For example, if the property is zoned for commercial use but there is high demand in the adjacent area for residential or multi-family properties, then the highest and best use of the land might not be commercial.
If on the other hand, it investigation reveals the site would be conducive to a commercial property but the zoning laws or neighborhood opposition would make change difficult, than you would have to weigh the time and effort involved in trying to get the zoning changed, and overcoming neighborhood objections against the future profits.
Another potential pitfall to be wary of is called a legal non-conforming use. This occurs when a building is presently being used legally for a purpose that was considered okay at the time it was built, but would not be okay if it were built today.
So a multi-family building built in an area that is now zoned as single family or duplex would be allowed to remain standing; however if the building were demolished it would not be permissible to re-build it even though you would be using it for the same purpose.
Whether or not upgrades to a site are physically possible requires an appraiser to consider factors such as whether or not the site is large enough for the proposed change, whether the site can be divided into smaller sites, and how the size, shape, accessibility, and topography of the site affect the construction of the proposed improvement.
Additionally, a property may be utilized for a purpose that is legal, but not typical for the neighborhood, which would be called a non-conforming use of the site.
This question asks whether or not the improvements that are being considered would garner more profit than the present use. For example, if a office building were to be renovated with the highest standard of materials in an area that has low demand for that standard, then such a property would be hard to rent out or sell and therefore, that type of improvement would not be considered financially feasible.
Or if a multi-family property would be renovated to include high-end kitchens and state of the art smart apartments in an area where demand is low for that standard of living, then that would also qualify as not being financially feasible and would be considered an over-improvement.
This category also includes the size of the property as well as its design.
The most profitable use differs from financially feasible in that it refers to whether or not the type of commercial property being considered is the most likely to return the highest profits.
In our hypothetical parking lot scenario, the question of whether or not a parking lot is the highest and best use of the site could only be considered after answering the first 3 questions. Other examples of properties where highest and best use should be considered before purchase are renovation of older office buildings vs conversion to mixed use, retail, or residential.
Although on the surface it might appear upgrading to a higher standard would be more profitable, increasing construction costs, neighborhood opposition, or substantial management responsibilities might mean that the highest and best use of that parking lot would be… a parking lot.