Determining Optimal Property Use

Chapter: Determining Optimal Property Use

This chapter delves into the crucial process of determining the optimal use of a property, a cornerstone of real estate valuation and investment decisions. We will explore the theoretical underpinnings and practical applications of Highest and Best Use (HBU) analysis, providing a structured approach to identify the most profitable and supportable utilization of a given parcel.

1. Introduction to Optimal Use

Optimal property use, in the context of real estate, refers to the utilization of a property that maximizes its value while being legally permissible, physically possible, financially feasible, and maximally productive. This is the core concept behind HBU analysis. The identified HBU is not static; it’s dynamic and subject to change based on market conditions, legal frameworks, and physical alterations to the property or its surroundings. It is important to distinguish between the physical use❓ of real estate and the motivations of the users (such as conservation, assemblage, or speculation).

2. The Four Tests of Highest and Best Use

The HBU analysis framework traditionally relies on four interdependent tests:

• Legally Permissible: The proposed use must comply with all applicable zoning ordinances, building codes, environmental regulations, and any private restrictions (e.g., deed restrictions, easements).
• Physically Possible: The site’s physical characteristics (size, shape, topography, soil conditions, access, availability of utilities) must be suitable for the proposed use.
• Financially Feasible: The proposed use must generate sufficient income or value to cover all costs of development, operation, and financing, and provide a reasonable return on investment.
• Maximally Productive: Among all legally permissible, physically possible, and financially feasible uses, the HBU is the one that generates the highest net return or value. This usually involves comparing the residual land values or rates of return.

3. Determining Legally Permissible Uses

This stage involves a comprehensive investigation of legal restrictions influencing the property’s use.

• Zoning Ordinances: These regulations dictate permissible land uses❓❓ (residential, commercial, industrial, agricultural, etc.), density restrictions (e.g., Floor Area Ratio (FAR)), height limitations, setback requirements, and parking standards.
• Building Codes: These codes specify safety standards for construction, including fire protection, structural integrity, and accessibility.
• Environmental Regulations: These regulations address potential environmental impacts, such as wetlands protection, hazardous waste remediation, and air and water quality.
• Private Restrictions: These restrictions, established through deeds or agreements, can limit land use, architectural styles, or other aspects of property development.
• Probability of Change: Appraisers should investigate whether there is a reasonable probability of a change relative to the subject property along with economic demand for change and any timing and cost considerations related to a potential change.

4. Assessing Physically Possible Uses

This stage focuses on the physical attributes of the site and their impact on potential uses.

• Site Characteristics:
  • Size and Shape: Irregular shapes can increase development costs and limit functionality.
  • Topography: Steep slopes or uneven terrain can require extensive grading and increase construction expenses.
  • Soil Conditions: unstable soils❓❓ may necessitate soil stabilization measures, adding to development costs.
  • Access: Adequate access for vehicles, pedestrians, and utilities is essential for most uses. For developers of industrial property, the access of the site for large trucks may be the most significant physical attribute.
  • Utilities: Availability of water, sewer, electricity, gas, and communication services is crucial.
• Property Productivity Analysis: The information that appraisers use to analyze the physical possibility of a land use is often collected in the property productivity analysis step of the market analysis process, which also covers the legal and locational characteristics that connect the property with sources of economic demand and set it apart from its competition.

5. Evaluating Financial Feasibility

This stage involves a detailed financial analysis of alternative uses, considering potential income, expenses, and investment returns.

• Income Projection: Estimate potential revenue based on market rents, occupancy rates, and sales prices for comparable properties.
• Expense Estimation: Project operating expenses, including property taxes, insurance, maintenance, utilities, and management fees.
• Development Costs: Estimate construction costs, including materials, labor, permits, and financing charges.

• Discounted Cash Flow (DCF) Analysis: DCF analysis is used to determine the present value of future cash flows, considering the time value of money. The Net Present Value (NPV) is calculated as follows:

  NPV = ∑ (CFt / (1 + r)^t) - Initial Investment

  Where:

  • CFt = Cash flow in period t
  • r = Discount rate (required rate of return)
  • t = Time period
  • Residual Land Value: The land value remaining after deducting development costs and required returns from the project’s total value.

  Residual Land Value = Property Value (as if complete) - Development Costs - Required Profit

6. Determining Maximally Productive Use

This is the final stage, where the financially feasible uses are compared to identify the one that yields the highest return or value.

• Comparison of Residual Land Values: The use that generates the highest residual land value is considered the HBU.

• Rates of Return Analysis: Rates of return that reflect the associated risks of alternative uses are often used to capitalize the residual income to the land from those uses into their respective values.

  Land Value = Net Operating Income / Capitalization Rate
  * Comparable Sales Data: Land sales can be used to test which alternative is maximally productive when the comparable plots of land have the same or similar highest and best use conclusions as the subject property.

7. HBU as Though Vacant vs. HBU as Improved

The HBU analysis must be conducted from two perspectives:

• As Though Vacant: This analysis determines the optimal use of the land as if no improvements existed. It involves considering potential development scenarios without constraints imposed by existing structures.

• As Improved: This analysis determines the optimal use of the property considering the existing improvements. It may involve:

  • Continuing the Current Use: Assessing whether the current use is still the HBU given market conditions.
  • Modifying the Existing Improvements: Evaluating options for renovation, conversion, or alteration to enhance value.
  • Interim Use: Identifying a temporary use that generates income while awaiting future development.
  • Demolition and Redevelopment: Determining if demolition and redevelopment are economically justifiable.

  If the value of the property as improved is greater than the value of the site as though vacant less demolition costs, then the existing improvements contribute value to the property’s highest and best use and should not be demolished at that time.

8. Alternative Uses of the Real Estate as Improved

In market value appraisals of improved property, appraisers consider a number of alternative uses of the existing improvements:

• Retain the existing improvements and continue the current use as the highest and best use.
• Convert, renovate, or alter the existing improvements to enhance the current use or change the use of the property to a more productive use.
• Retain the existing improvements and continue the current use as an interim use.
• Demolish the existing improvements and redevelop the site.

For any of these options to be financially feasible, the change must add at least as much value to the property as it costs. In other words, the value after conversion, renovation, or alteration less the costs of the modification (including entrepreneurial incentive) must be greater than or equal to the value of the property as is.

9. Ideal Improvement

If the HBU analysis indicates that a new building improvement is appropriate for the highest and best use of a parcel of vacant land, the appraiser then determines and describes the type and characteristics of the ideal improvement to be constructed. The use that is considered the ideal improvement should meet the following criteria:

• It is supported by market and marketability analysis and the financial analysis of alternative uses.
• It takes maximum advantage of the potential market demand for the site’s highest and best use.
• It conforms to current market standards and the character of the market area.

10. Consistent Use Principle

The principle of consistent use holds that land cannot be valued based on one use while improvements are valued based on another use. In other words, if the improvements are not the highest and best use, any reduction or increase in value they create would be attributed to the improvements, not the land.

11. Case Studies and Examples

• Example 1: Vacant Land Analysis

  A vacant parcel is zoned for either residential or commercial development. Residential development yields a residual land value of $50/sq ft. Commercial development yields a residual land value of $75/sq ft. Therefore, the HBU is commercial development, assuming both uses are legally permissible and physically possible.

• Example 2: Improved Property Analysis

  An older office building is located in an area experiencing a shift towards residential development. The appraiser must consider whether to: a) continue operating the office building, b) renovate the building for residential use, or c) demolish the building and redevelop the site with apartments. A detailed financial analysis of each option is required to determine the HBU.

12. Conclusion

Determining the optimal property use is a complex and multifaceted process that requires a thorough understanding of market dynamics, legal regulations, and financial principles. By systematically applying the four tests of HBU and considering both the “as vacant” and “as improved” perspectives, appraisers and investors can make informed decisions that maximize property value and achieve their investment goals.