Highest and Best Use: A Superpower You Already Possess

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Like the Incredible Hulk, my superpower didn’t show itself until stressed. That stress came in January 2020, when Minneapolis became the first major U.S. city to eliminate single-family residential (SFR) zoning, allowing one-to-three units to be built on what were previously (SFR) parcels. Suddenly, there was a lot of confusion in the appraisal community about when and how to perform the highest & best use (H&BU) analysis for the new zoning classification. 

As chapter president of the North Star Chapter of the Appraisal Institute, I fielded a flood of questions from residential appraisers to state regulators. One thing I quickly realized was that many of the residential appraisers I spoke with didn’t know the four tests of H&BU analysis. 

Let’s revisit the basics: In an H&BU analysis, real estate appraisers determine the most probable use of a property by applying four tests: whether the use is legally permissible, physically possible, financially feasible, and maximally productive. Order doesn’t matter for the first two tests, but it’s essential for the last two. Moreover, appraisers must conduct each of the four tests on the real property as if vacant, and as improved. 

Applying each of these tests properly is essential to the valuation process. In many litigation situations where appraiser’s values are far apart, it’s due to H&BU analysis differences.

 

H&BU: A Quick Review

Legally permissible – Does the use comply with zoning regulations and other legal requirements? 

In this test, you’ll examine zoning and building codes, variances, deed restrictions, building covenants, and easements to assess a range of legal uses for the subject property. This requires a little detective work. Some of this information isn’t available online, so you may have to pay a visit to your local planning department. Variances can be especially tricky to find, but they can also have a major effect on a potential use, so don’t neglect them.   

Physically possible – Can a specific use be built? 

First, inspect the site. Consider parcel size, topography, condition of improvements, and any environmental features that could limit certain uses: Is there solid bedrock or soft soil? Level ground or a steep slope? Does the area flood? And can the proposed structure be built in compliance with codes once you consider setbacks, height restrictions, and floor-to-area ratio? 

Next, consider infrastructure issues that could restrict potential uses: Is the property accessible by road and connected to utilities and public services? Will their capacities support the proposed use? Don’t hesitate to consult with an architect, engineer, or  surveyor if you’re not 100% sure whether to include or eliminate a proposed use. 

Financially feasible – Would the proposed use generate enough income to pay for construction costs and make a profit?

In this test, you’ll evaluate the subject’s financial viability for a specific use. This is the most intensive of the four tests — it requires a thorough market analysis, cost-benefit analysis, and financial projections. You’ll factor in supply and demand, costs of compliance and other expenses, infrastructure investments, rental income, vacancy rates, availability of credit, interest rates, permit fees required by local cities, and market trends when determining the financial feasibility for each potential use. 

Take the result(s) of this test and move on to the next one:  

Maximally productive – Which use would be the most profitable?

In this test, you’ll examine the output of one or more financially feasible uses and select the use with the highest productivity. Anticipation, market demand, and timing for each potential use are evaluated during this test to further reduce any uses. The result of this test is the most probable use of the real estate. Table X summarizes the four tests:

 

Practical H&BU Analysis 

At this point, you’re probably thinking: That’s a lot to remember! It’s easier to tackle if you think of H&BU analysis as a funnel, starting with many possible uses and ending with one. (See diagram.)

Let’s illustrate this with a simple example:

First, imagine a property with a minor improvement that has been “upzoned.” Upzoning is a movement sweeping the country — many cities are changing zoning laws to increase density and address affordable housing issues. Upzoning requires appraisers to have a firm grasp of H&BU analysis; since the new zoning allows for multiple uses, appraisers now have to consider them all.  

The subject property is a 30-year-old garage on a 3,000-square-foot parcel in the core city, and it has its own property identification. Street, sewer, water, gas, and electricity are available to the site. It’s zoned R1, which has a minimum parcel size of  6,000 SF to build. The owners live on an adjacent parcel and bought the remnant parcel at auction 31 years ago. They received a variance to put up a garage, which cost $15,000. Under the zoning requirements at the time, a SFR dwelling could not be built on the parcel.  

Recent passage of an upzoning ordinance allows for up to six units per R1 parcel with a minimum of 1,000 SF per dwelling. Under the old zoning, the H&BU analysis was finished at the legally permissible test. Moreover, scraping the garage wouldn’t increase the utility, since a SFR dwelling couldn’t be built due to the lot size. But with the new zoning, up to three units may be constructed on the property. Thus, H&BU analysis must be applied for both as vacant and as improved (See diagram). 

Let’s look at the as-improved H&BU: The current market value of the site is $30,000, demolition cost is $2,000, economic life of the garage is 50 years, and effective age is 30 years. The depreciated cost of the garage is $6,000; $15,000 * (1 – (30 years / 50 years)). Adding the cost of the garage and site value is $36,000. This is the value as improved. The as-vacant value is $28,000 ($30,000 – $2,000).

With the zoning change, it’s possible to build an SFR, attached duplex, or triplex dwelling. The building cost for a SFR, duplex, or triplex is $176,000, $340,000, and $550,000 respectively, which includes demolition of the garage. Market sales and rental data indicate a gross rent multiplier (GRM) of 110, a mean rental rate of $1,600/month for a SFR; $3,500/month for a duplex; $4,700/month for a triplex. As you can see, there are three potential uses. Now, let’s look at each case.

The single-family dwelling: Build cost is $176,000. To satisfy the financial feasibility for this case, the monthly income rate must be greater than or equal to the market rent for a SFR dwelling. This criterion is met: $1,600 in rent is equal to $1,600 ($176,000/110).

The duplex: Build cost is $340,000, and the calculated monthly income is $3,090.91 ($340,000/110). This use also passes muster, since the market rent of $3,500/month for a duplex, which is greater than $3,090.91. 

The triplex: Build cost is $550,000 and has a calculated monthly income of $5,000 ($550,000/110). For this case to pass, the market rent has to be greater than or equal to $5,000. Since the market rents for triplexes are $4,700, it fails the test.

 

Reconciliation

The as-improved and as-vacant values are discarded since they don’t significantly contribute value. This leaves the as-developed cases from the financial feasibility test for consideration. Only two of the three potential uses pass the test: SFR & duplex. Now you’ll run the two potential uses with passing grades through the maximally productive test. 

Comparing the two uses, the duplex seems to win, since its potential income is the greatest. However, please note that in some scenarios, you won’t necessarily select the maximally productive use. One example is timing — maybe the market doesn’t support duplexes in the neighborhood just yet. Another example would be if existing sewer & water capacity can’t support the increase in density.

When appraising a property in a subdivision in a town where the only legally permissible use is SFR, figuriing out the highest and best use can be pretty simple. Maybe you’ve gotten used to the simple — that house in a subdivision with strict limits on what improvements may be built. And you may have found yourself in a rut of H&BU as fait accompli.

But when the underlying rules change (e.g., SFR zoning is eliminated), your inner David Banner may have to summon superhuman strength, morph into a super-analyst, and do some serious highest-and-best-use heavy lifting. Fortunately, you won’t need to bombard yourself with gamma radiation to attain this superpower — it’s already within your skillset as residential appraisers to consider all points of highest and best use and work your way to a supportable indication of maximally productive use for a property. Maybe you just need to refresh your memory on the specific steps, and then you can embrace a superpower you’ve had all along.