Valuation matters – Appraisers apply four tests to determine highest and best use

An important factor for an appraiser to consider when valuing real property is its “highest and best use.” This may not necessarily be its current use, though.

The Appraisal Institute defines highest and best use 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.” Appraisers typically apply four tests to determine that use.

Physically possible

Early in the valuation process, an appraiser determines which uses are physically possible on the property. This step considers such attributes as the site’s size, shape, topography, soil type, water conditions and accessibility.

For example, is the property large enough to build an improvement? Is it flat or sloping, and which is typical in the area? This test doesn’t consider any zoning or economic restraints, only physical potential.

Legally permissible

This test is also performed early in the valuation process. The scope of the inquiry goes beyond whether zoning restrictions allow the proposed use. It contemplates restrictive covenants, building codes and regulations, easements, height limits and the like, as well as whether the current use is a legal nonconforming use that was “grandfathered” in but is now impermissible.

Notably, the existence of a legal restriction doesn’t necessarily mean a proposed use (for example, a development) can’t be the highest and best use. The appraiser might find the restriction is likely to be changed to allow the use.

Financially feasible

For uses that are “reasonably probable,” because they’re both physically possible and legally permissible, the appraiser performs various financial analyses and calculations to determine their financial feasibility. The work might include market analysis, cash flow estimates and net operating income projections.

A potential use generally is considered financially feasible if its net present value (NPV) is greater than zero. Only uses that satisfy the first three tests are then subjected to the final test.

Maximally productive

Finally, the appraiser ranks the remaining uses according to value or rate of return, adjusting for associated risks. This means that the use with the highest internal rate of return (IRR) might not come out on top if the use is excessively risky. The use with the highest risk-adjusted IRR and NPV is the maximally productive use and, ultimately, the highest and best use of the property.

More complicated than it looks

These highest-and-best-use tests aren’t always straightforward to apply, particularly when the property already has improvements on it. Invest in a qualified appraiser to obtain the most reliable results. Contact an Elliott Davis advisor for more information.