Highest and Best Use is a term that you will often hear in relation to whether or not a real estate investment should be made. Highest and Best Use is a tricky concept because the term is subjective and relative.
Subjectivity
Highest and Best Use is subjective because there are several components that can’t necessarily be measured such as risk, future value, the probability of future outcomes, and non-monetary value.
Relativity
Highest and Best Use is relative because different parties and people have different perspectives on a project or piece of land. A seller may have a different Highest and Best Use in mind than a prospective buyer and therefore the two parties will have a different value of the land or parcel. These different values could be higher or lower than one another. If the prospective buyer’s value is lower than the sellers, a transaction will not take place and the parcel stays as-is.
Highest and Best Use is also relative based on how fully vetted a real estate investment is and the status of major components of risk. One such component of risk is the value of finding a tenant.
Let’s say two developers are looking at the same piece of land. Developer A looks at the deal as either an office development or a multifamily project. They have no existing relationship with any office tenants and would have to find an office tenant in the open market. After their evaluation, they determine the Highest and Best Use is multifamily. Developer B also evaluates the same piece of land, but they have already had a conversation with an office tenant who wants to move to that part of town and is willing to sign a lease. With an office tenant in hand, Developer B determines that the Highest and Best Use of the land is office and is willing to pay more for the land than Developer A. If the price that Developer B is willing to pay is more than the seller is willing to accept, than a transaction may take place and an office building may get built.
Elements of Highest and Best Use
There are several elements and factors that contribute to the Highest and Best Use of a property. I have listed them below and then will share my thoughts on each, one at a time.
- Current State
- Risk
- Potential Price and Rent
- Regulation (zoning, change of use, code changes)
- Cost
- Non-Monetary Values
- Seller Price and Motivation
Current State
The current state of the property is one of the largest contributing factors to a Highest and Best Use analysis. Any real estate investment decision is made based on creating marginal value. Marginal value is the difference between the potential future value of the investment and the current value of the investment. Any value created in an investment is “on the margin” (or added to the edge) of the existing value.
Because we are evaluating marginal value, the higher the value of the current state of the property in question, the less likely it is that an investment will create enough marginal (or additional) value to be worth making after taking into account the other factors listed below.
As an example, if two identical neighboring parcels are for sale. One is a greenfield site (has never been developed) and one has a small house on it. Both properties could be developed into four townhomes of equal value. The greenfield site is more likely to have a Highest and Best Use of townhomes (depending on the results of an investment analysis) because of the lower value of the current state of the property. The greenfield site will have a lower cost of acquisition, lower demolition costs, less risk associated with environmental contamination of the land, a lower risk of remediation (removal of hazardous substances like mold, asbestos, and lead based paint) required, and lower overall risk.
Risk
Any discussion of Highest and Best Use must be a discussion of risk. All investment decisions will be based on a degree of unknown factors. The investments will also be compared against alternative investments of varying degrees of risk. If choosing between multiple investments with the same potential financial returns, the investment with the lower overall risk profile will be chosen.
Risk in a development project can take many forms. There are risks associated with time, rental and sale outcomes, cost of construction, environmental risks, regulatory risks, political and community risks, operational risks, safety, and more.
Acquisition risk is another risk worth discussing that is separate from project delivery risk. When developing a project, the more parties that are involved or the larger the number of parcels involved, the higher the risk and complexity. Acquisition risk tends not to be linear, but more often exponential. Acquiring two separately owned sites is more than twice as complicated and risky as acquiring one site, which is why you most often see projects built on a single parcel.
Some of these risks are minor and some are major, but the entire risk spectrum must be taken into account when evaluating Highest and Best Use. At the end of the day risk must be subtracted out of the potential future of a project. The higher the risk, the less valuable the outcome. Risk can be thought of as a tax on project success.
Potential Price and Rent
One of my favorite quotes about development comes from John Anderson and is “if you can’t get the rent, you can’t build the building”. People often forget that no amount of investment will allow the developer to set the market price or set the rent for a project. Developers can only deliver value up to what the market will support. If developers could “set” the market price for a home or rent for a building, development would be far less risky.
Potential sale price and rent in a market are set by supply and demand. It is possible for a new development to deliver above the highest rent/price in the market, but only if the existing market supports that higher price. You most often see this phenomenon in a supply constrained market or a market that is growing quickly.
If the existing demand – or demand at the time of future delivery – isn’t high enough to support the project financially, the developer runs the risk of not being able to pay their investors and lenders and the project will fall into bankruptcy. A developer typically carries the majority of the financial risk, meaning a failed project can be financially catastrophic to them. In this situation, the project will be sold and a new buyer will offer a price that is supported by the market, often a price lower than the cost of the original project. This process is called “marking to market”.
New development happens “at the margin” in a submarket where pricing and rent is high enough to support new construction. The higher the demand – or gap between price/rent supported by the market and the cost to deliver new projects – the more development will be delivered in a healthy market. The price or rent that the market can support can be thought of as the “market ceiling” or “price ceiling” of a neighborhood and the minimum costs of delivering new space that is acceptable to the market can be thought of as a “cost floor”. You will only see new development, at the margin, in areas where the price ceiling is far enough above the cost floor to overcome all of the challenges, obstacles, and risks of delivering the project. Again, if you can’t get the rent, you can’t build the building.
The price ceiling is always on the move and changes across a city and across time. The cost floor is dependent on land cost and regulation, but for the same size and type of structure remains fairly constant across a given market. The cost to build a three story apartment building is fairly constant across the city, so you will only see new construction where rents are high enough, and risk and land cost are low enough to justify new construction. In some areas the price ceiling is high enough and the cost floor is low enough for new construction, but new construction is prohibited through regulation and exclusionary zoning.
Regulation
The regulations associated with a project can impact the Highest and Best Use of a site from several sources and at many times in the life of a site.
Regulation on a site is applied at many levels, the City, the County, the State, and the Country. In some places there are also City level regulations that only apply to certain areas within the City.
These regulations include zoning and use regulations, building codes, life safety codes, environmental regulations, development fees and taxes, and many other forms.
When thinking about Highest and Best Use for a site or project it is also important to understand the regulations in three different buckets of time. There are the current regulations, the future regulations, and the regulations associated with change of use.
The current regulations include all regulations that apply to the site or project as it is, also called “by right” regulations.
Future regulations include all regulations that would apply to a site after a regulatory change – often through a rezoning – is accomplished.
Change of use regulations are the regulations that only come into effect if the use of a building is changed, say from a warehouse to an office. If you see a building that is vacant or underutilized in an otherwise thriving neighborhood, it is often because the costs associated with change of use are too high to justify making the change.
Cost
Each site or project also has associated costs that will impact the Highest and Best Use. As mentioned above if you can’t get the rent, you can’t get the building. That said, even if the rents seem to be there, if the costs are too high, no development will take place.
Costs can fall into several buckets depending on the type of cost and the timing of the project. You will often hear of hard and soft costs, and dollars can be spent in preparation for and execution of the project.
Hard costs are the “sticks and bricks” costs of construction. Soft costs are associated with design and approval of a project. Paying for an architect to design a building or a civil engineer to design a site are examples of soft costs, so are impact fees and permit fees associated with approval for a project. Paying your general contractor for building a project is an example of a hard cost.
Preparation costs are spent on a building or site to get it ready for site or building specific investment. A site might have relatively higher preparation costs if the soil is especially rocky, contaminated, or otherwise not suitable for construction. Building preparation costs can include surveys, testing and measuring, demolition, and/or remediation of mold, asbestos, or lead based paint.
The higher these costs are relative to alternative or comparable sites, the lower the Highest and Best Use of that site will be.
Costs can also be incremental or fixed. The price of a parcel of land is a fixed cost, but the cost of each home built on the land is an incremental cost. Depending on the density allowed on a site, the fixed cost of land can be “lowered” for each additional home or square foot of commercial property built on a site. Higher density can often allow a developer to pay a higher total price for a piece of land because the project can support a certain incremental price for each unit or amount of space they can build.
Non-Monetary Values
Some values that aren’t tied directly to investment dollars that can impact Highest and Best Use are historic, natural, proximity, and more.
Historical value includes events that have happened on the site, people who have lived there, or design and building aesthetics that feature historical significance.
Natural value can include both protected species as well as resources such as forest and waterways that are protected for the benefit of the community.
Proximity can impact the Highest and Best Use of a site in positive and negative ways and depending on the perspective of the parties involved. Highway proximity might be a negative value for one party and a positive value for another.
Seller Price and Motivation
A seller’s expected price and motivation can also impact Highest and Best Use of a site. If a seller expects their land or building to sell for more than the market can support, then no transaction will take place. The same can be said for motivation. If a seller would accept the market price to allow for a transaction, but merely does not feel motivated to sell, no transaction will take place. Seller price expectations being off of market and or seller motivation are another reason you often see projects or parcels stay frozen in time year after year.
Conclusion
Highest and Best Use for a building or parcel is a complicated subject and consists of several subjective and objective criteria. Also, Highest and Best Use reacts to an ever changing landscape of movement in the price ceiling and cost floor of a development environment.
If you have any questions about highest and best use, please drop them in a comment below or send me an email at [email protected].
