When determining property value, one of the most critical concepts in real estate appraisal is highest and best use (HBU). Professional standards require appraisers to develop an opinion of HBU when necessary for credible assignment results. HBU refers to how a property should be used to generate maximum value under specific constraints, not necessarily how it’s currently being used.
Definition of Highest and Best Use
In professional appraisal practice, Highest and Best Use is defined as “the reasonably probable and legal use of vacant land or an improved property that is physically possible, appropriately supported, financially feasible, and that results in the highest value” (Appraisal Institute, The Dictionary of Real Estate Appraisal, 2022). This definition emphasizes that HBU must be reasonably probable, not merely possible or speculative.
Appraisers must analyze the property as vacant land, and as improved, considering what is legally permissible, physically possible, financially feasible, and maximally productive in the current market.
Why Highest and Best Use in Appraisal Matters
Highest and Best Use gives stakeholders insight into a property’s worth at its full potential. It guides market value determinations that reflect the property’s full potential and informs development and investment decisions based on feasibility and profitability. Additionally, HBU supports lending and underwriting decisions, especially for construction loans or redevelopment projects, guiding land use planning and zoning analysis in transitioning neighborhoods.
The Four Tests of Highest and Best Use in Appraisal
Appraisers apply four tests to identify which use adds the most value to a property.
Legally Permissible
The first test evaluates what is legally permissible on the property. This includes examining zoning ordinances, building codes, land use regulations, deed restrictions, and environmental regulations. Private restrictions, such as easements and covenants, must also be considered, as they can significantly limit potential uses. Only uses that comply with all legal constraints move forward to the next test.
Physically Possible
The second test assesses the physical characteristics of the property to determine what is feasible. Appraisers consider the lot size and shape, topography, access to utilities, ingress and egress, soil conditions, and environmental factors. The physical analysis should also evaluate the surrounding infrastructure and its capacity to support various uses. The site’s physical attributes often eliminate many legally permissible uses from consideration.
Financially Feasible
The third test determines economic viability by analyzing whether potential uses would generate sufficient income or value to justify development or conversion costs. Appraisers must consider market demand for the proposed use, construction and development costs, potential income or sales prices, and expected return on investment. This requires thorough market analysis examining supply and demand factors, absorption rates, and competitive positioning. Only property uses that promise a positive return advance to the final test.
Maximally Productive
The fourth and culminating test identifies which legally permissible, physically possible, and financially feasible use produces the highest value or return. This analysis applies to all property types—residential, commercial, industrial, and special-purpose properties alike. For example, if a property could legally and physically support either a retail center or an apartment building and both are financially feasible, then the appraiser must determine which use generates the highest residual land value or net return.
Determining Highest and Best Use
The Highest and Best Use determination process requires comprehensive market analysis and distinct analyses of the property “as vacant” and “as improved.”
Market Analysis: The Foundation
A thorough market analysis forms the foundation of credible HBU determination. This analysis examines supply and demand factors for various potential uses, studies competitive properties and their performance, analyzes absorption rates and market trends, and considers demographic and economic factors affecting property values. It also evaluates the regulatory environment and potential changes. This market analysis informs all four tests but is particularly critical for financial feasibility and maximum productivity determinations.
HBU Analysis Framework
The process involves three interconnected analyses. First, the Land as Though Vacant Analysis identifies potential uses that pass all four tests, determines which use would generate the highest land value, and establishes a baseline for comparing the value contribution of existing improvements. The first part of determining Highest and Best Use involves researching legal constraints and analyzing physical characteristics, with financial feasibility determined through comparative market analysis and demand evaluation.
Second, the Property as Improved Analysis examines the property with its existing improvements to determine whether the current use represents the property’s HBU, if modifications to existing improvements would increase value, and if demolition and redevelopment would yield higher value than the current use. This analysis compares the property’s current value to its value under alternative scenarios, including renovation, conversion, expansion, or redevelopment.
Finally, the Comparative Analysis compares the results of both previous analyses. If the value of the land as vacant (less demolition costs) exceeds the value of the property as improved, this suggests demolition and redevelopment represent the Highest and Best Use. Conversely, if the property as improved generates greater value than alternative uses of the vacant land, then maintaining or enhancing existing improvements represents the HBU. Appraisers should consider both short-term and long-term profitability in this analysis.
Special Considerations in HBU Analysis
Several special considerations often arise in HBU analysis that experienced appraisers must address. When market conditions don’t currently support the ultimate Highest and Best Use of a property but may do so in the future, appraisers must consider interim uses that maximize value until conditions improve.
For example, a downtown parcel might have an ultimate HBU as a high-rise office building, but current market conditions don’t support such development. An interim use, such as a surface parking lot, might represent the current HBU if it meets the four tests—legally permissible, physically possible, financially feasible, and maximally productive—until market conditions improve.
Experienced appraisers must also distinguish between excess and surplus land in their Highest and Best Use analysis. Excess land is land that could be separated from the primary site, such as a subdividable parcel. It has an independent highest and best use, so it should be valued separately. Surplus land, however, cannot be separately utilized or developed due to zoning, physical constraints, or other limitations, but may contribute to the value of the improved property and is valued as part of the primary site. This distinction is crucial for accurate valuation, particularly for properties with large land areas relative to their improvements.
Highest and Best Use analysis for special-use properties such as religious facilities, schools, or highly specialized industrial facilities presents unique challenges. For these properties, appraisers must consider the concept of “value in use” versus “value in exchange,” limited marketability and specialized buyer pools, potential for adaptive reuse, and the contribution of specialized improvements to value. The HBU of special-use properties often depends on the specific needs of a limited market segment, requiring careful market analysis and consideration of alternative uses.
Finally, appraisers must recognize that Highest and Best Use is dynamic and can change with market conditions, regulations, and technological advancements. They must consider current market trends and their trajectory, potential regulatory changes affecting permissible uses, emerging uses that might not have historical precedent, and alternative scenarios based on different market projections. This forward-looking aspect of Highest and Best Use analysis is particularly important in transitioning neighborhoods or rapidly changing markets.
Conclusion
Determining the highest and best use requires multiple valuation methods and professional judgment. Appraisers must evaluate properties as vacant and as improved, systematically applying the four tests: legal permissibility, physical possibility, financial feasibility, and maximum productivity.
The Highest and Best Use analysis forms the foundation for credible valuation opinions through rigorous market analysis and a thorough understanding of physical and legal characteristics. It represents one of the most analytical aspects of the appraisal process and directly influences the final value conclusion. As market conditions and regulations evolve, so does a property’s Highest and Best Use. Appraisers who stay current with industry trends and changing regulations maintain a competitive advantage—that’s where McKissock Learning can be your trusted ally.
McKissock Learning offers appraisal continuing education and license renewal courses in every state, including Residential Market Analysis and Highest and Best Use. With the new student dashboard, keeping track of what’s required in your state and the electives that interest you has never been easier. Browse our large selection of CE courses relevant to industry trends, practical application, and career advancement.
