Highest and best use analysis for mixed-use developmentReal Estate & Construction
Highest and best use analysis produces the highest value for a property based on the concept of maximum productivity. The Appraisal Institute defines highest and best use as follows:
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.
The four criteria the highest and best use must meet are:
Legal permissibility:
In the highest and best use analysis, we should only consider those uses that are legally permitted. Analysis excludes uses that are not permitted by zoning, land-use planning, uses forbidden by the government regulations and any other uses that are prohibited by the deed restrictions.
However in the analysis, we may explore uses that are currently not legally possible – but there is a reasonable prospect that the regulation, zoning, deed restriction, etc. may be challenged with the concerned authority for the proposed use.
Physical possibility:
Any use being explored must be physically possible given the size, shape, topography, and other characteristics of the site. Most of the time it boils down to engineering!
Financial feasibility:
The highest and best use of a property must be financially feasible. I.e. any proposed use must not only generate adequate revenue to justify the costs of construction but also make a profit for the developer.
Maximum productivity:
The potential use must generate the highest return to the developer. Highest return can mean different thing to different people – IRR, NPV, development profit or residual land value.
In our opinion, the use that generates the highest net present value is the highest and best use because it takes into account both time value of money and the cost of capital into account.
The tests of physical possibility and legal permissibility must be applied before the tests of financial feasibility and maximum productivity. A use may be financially feasible, but this is irrelevant if it is legally prohibited or physically impossible!
For the subject site the following uses are legally permissible:
- Retail
- Residential
- Commercial
- Hospitality
Our initial research indicates the above construction cost and sales prices for each use:
It is very clear that the hospitality use gives the maximum profit! The analysis indicates that hospitality is the highest and best use.
Maximum productivity and market constraints
Market forces create market value and put various constraints on the highest and best use analysis. Consider a situation where a potential use may give the highest return but the competitive forces where the property is located allows limited marketability of the said use. A thorough market analysis is very critical to see if the potential use can be absorbed by the market.
Another thing which should be kept in mind while doing highest and best use analysis is site location and surrounding developments. Market analysis may suggest that there is demand for a large office building in the community. However, if single-unit residential developments surround the subject site, a large, multi-story office building would probably not be a reasonably probable use, even if it were legally permitted.
On the other hand, there may be a significant demand for a use in the market area of the subject site, and the site may be suited for this use, but a number of other sites may be equally or more appropriate. You must ensure that the existing and potential competition from other sites has been fully recognized.
The municipal authority has dictated few guidelines for the development! We had to respect that and take all into consideration.
The market research team has completed the assessment of the market thoroughly reviewing the demand and supply dynamics.
By the time project is constructed and delivered to the market, the market situation will be such that it can absorb 500,000 m2 of retail, 900,000 m2 of residential, 800,000 m2 of commercial and 200,000 m2 of hospitality.
Taking into the accounting model the construction cost and sales price values.
We have solved this using the linear programming tool and the highest and best uses numbers we generated for the fully satisfied customer.
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