Real Estate Terms

Principle of Highest and Best Use in Real Estate

The principle of highest and best use is one of the many appraisal principles appraisers use to determine fair market value for a property. This article discusses highest and best use, its criteria, real estate appraisal, and what you need to know come exam day.

What Is the Principle of Highest and Best Use?

The principle of highest and best use of a property is the concept that finding the best use of real estate would create its greatest net return.

This appraisal principle is designed to ask a simple yet complex question: What is the maximum way to achieve the most significant return on a particular parcel of real estate OR what is the highest and best use?

The highest and best use of a property is the use of a property that would create the greatest net return over time. Sometimes highest and best use is referred to on the real estate exam as the greatest net return. Don’t be concerned if you see this. Highest and best use and greatest net return can be used interchangeably.

The principle of highest and best use is one of the many appraisal principles appraisers use to determine fair market value for a property. Using the highest and best use principle, geographic location, comparable properties, real estate market trends, and more, appraisers can accurately determine a fair price for properties.

What Is an Example of Highest and Best Use?

Let’s say you owned a vacant lot in a residential neighborhood. If you constructed a parking garage in that residential neighborhood, chances are you would not be getting the highest value from that property. Instead, building a house would be a safer bet and thus would be the highest and best use.

Highest and Best Use in Commercial Real Estate

Highest and best use in commercial real estate is extremely important. Let’s say you own a large mall or shopping center, but it has some age on it and is a bit rundown. The land is excellent and stretches well over 25 acres, so you decide to evaluate it. 

Using the income approach, comparative approach, and finding its replacement cost, you come up with a value for that use. But let’s say you want to see what other uses the property might have. 

Let’s say instead of using the property as a mall; you redevelop it as a multifamily apartment complex. And as it turns out, if the zoning allows it, a multifamily apartment complex would have a higher and better use than a mall. Boom! There you go; you just used the highest and best use principle to make a decision.

Now obviously those are some simplified examples, so how does it really work?

What Four Considerations Determine the Highest and Best Use?

Four criteria exist to determine a property’s highest and best use. Appraisers must ask themselves these four questions:

  1. Is it Physically Possible?
  2. Is it Legally Permissible?
  3. Is it Financially Feasible?
  4. Is it Maximally Productive?

Physically Possible

It would be fantastic to own an airport in your backyard that way instead of waiting for hours at the airport you can hop on a plane within minutes! Unfortunately with only a few acres that wouldn’t be physically possible. Appraisers must consider physical attributes when exploring the highest and best use.

Legally Possible

Remember earlier when I said, “if the zoning allows it,” well, it’s true that appraisers must factor in zoning, laws, land use controls, government regulations, and more to determine its highest and best use. A Starbucks in a residential neighborhood might do well but if the local zoning laws don’t allow it, then using the property to sell mocha Frappuccino’s is not the way to go.

Financially Feasible

If it yields the greatest net return, it must be financially feasible. If there’s no way to net a return, it won’t be possible and thus not the highest or best use.

Maximally Productive

Maximally productive or maximum productivity is the highest and best use. This one is pretty self-explanatory as it circles back to the core principle of highest and best use. Remember, regardless of the use appraisers find, whatever has the greatest net return and follows these four questions is the highest and best use.

What to Know for the Real Estate Exam

When exam day comes, you need to be familiar with what we talked about today. Remember, the principle of highest and best use of a property is the concept that finding the best use of real estate would create its greatest net return. Sometimes highest and best use is referred to on the real estate exam as the greatest net return and those terms can be used interchangeably. Understand the four criteria that exists to determine a property’s highest and best use, and you’ll be good to go come exam day.

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