January 20

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What is a Highest and Best Use Analysis, Who Needs One, and Why?

By Ken Jones

January 20, 2021

agent, broker, highest and best use, investment, investor, real estate, value

Exactly, which is a highest and best use analysis?

Before I explain what a highest and best use analysis is, for those of you who may not be familiar with the term, "highest and best use," or what it actually means, let me first define it for you then explain how the highest and best use of a property is determined.

The first, and probably the most important thing to understand about highest and best use, is that its conclusion, or the determination of what the highest and best use of a property is, is an opinion. That's right. It's an opinion, not a fact.

And, like any other opinion, an opinion of the highest and best use of a property is only as good as, 1) the information considered when forming that opinion, and 2) the knowledge, experience, and objectivity of the person who is forming that opinion.

You might be thinking, "So, if it's an opinion, how can it be taken seriously?" And, that's a perfectly reasonable question; it shows you're thinking objectively. So, here's the answer.

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In order for an opinion of highest and best use to be considered reasonable and reliable, the person who's developing that opinion must develop that opinion by submitting the subject property - being the property being analyzed - to four specific tests. In fact, every property whose highest and best use is being analyzed must be submitted to the same four standardized tests which are identified in the following definition of highest and best use, which says:

The highest and best use of any parcel of real estate, is that one use, from among all other potential uses, that:

1. Is legally permitted, or has the reasonable probability of becoming legally permitted;

2. Is physically able to be physically supported by the land and available infrastructure;

3. It provides a reasonable and competitive return on invested capital; and

4. In the event more than one potential use meets all of the three previous tests, then that one use which creates the highest present value of the real estate must be considered the highest and best use.

highest and best use

Let's assume that someone reading this article owns is thinking to themselves, "Well, I own a 12-unit apartment building, and I'm doing pretty good with it. So, why should I waste my money on getting a highest and best use analysis?" Again, this is a very reasonable question.

So, to best answer this question, I've created an example of a highest and best use analysis of this hypothetical 12-unit apartment building, and let's see if its owner would or would not benefit from having one performed on that property.

EXAMPLE:

This existing 12-unit apartment building is a 2-story structure built in the early to mid 1970s. It's sited on a 1-acre corner lot with eight 700 square foot 1-bedroom, 1-bath units, and four 800 square foot 2-bedroom, 1-bath units. There's a small 2-machine coin-operated laundry in a basement room, and a paved parking lot in the back of the building.

It's located within a few blocks of a commuter train station, and there's a revitalized downtown area with shops and a few decent restaurants in the vicinity of that commuter train station.

In the early to mid 1970s when this building was constructed, the world was a very different place. People's lifestyles and tastes have changed dramatically since then, including their expectations of what they expect their rental apartment to look like and the amenities it should have.

Today, a large and growing number of residential tenants expect to have matching stainless steel kitchen appliances that include a built-in dishwasher, either a countertop range or a range/oven, and a built-in microwave.

In 1-bedroom units, they want at least 1½ baths, and 2-full baths in 2-bedroom units.

And, they want a full-size clothes washer and dryer inside their apartment; they're not willing to run down to the basement with baskets o laundry, or worse, taking their laundry to a laundromat. Those days are in the rearview mirror.

Today's residential tenants also want convenient access to either public commuter transportation or highway access; and, preferably both. They also want to be close to good restaurants, shopping, and entertainment venues.

In short - today's residential tenant wants it all. And, the best part is, in many places, they're both willing and able to pay for it.

So, while our hypothetical 12-unit apartment building doesn't have all the features required by this large and growing number of today's residential apartment tenants, it's still running at full capacity. So, why would its owner consider replacing it with anything else?

Well, let's start by taking a look at the income and expenses from this hypothetical 12-unit apartment building.

The landlord is getting $1,100/month for each 1-bedroom unit and $1,350/month for each 2-bedroom unit and tenants pay for their own electric and cooking gas. The landlord supplies heat and hot water, and pays all other expenses, including water and sewer charges.

With these rents, the landlord has a potential gross income (PGI) of $170,400. And, as we noted earlier, this building is running at 100% occupancy.

But, even at 100% occupancy, there's always some minor loss of income when a unit goes vacant between tenancies when the unit has to be cleaned and painted. So, allowing for a minimal loss of income of 5% ($8,520), the landlord will actually collect $161,880; this is called the "effective gross income," or "EGI."

TAKE NOTE that, for the sake of a fair analysis, we're only going to consider the actual expenses necessary to operated this property; we are not going to consider the payment of mortgage principal and interest payments.

highest and best use

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Let's assume these are the actual expenses being paid by the owner of this hypothetical 12-unit apartment building that we can see in the graphic, you'll note that we've accounted for the real estate taxes at $28,500 (at about 2% of assessed value), $3,000 for fire and liability insurance, Gas for the tenants' heat and hot water, as well as for heating interior common space and hot water for the clothes washer and utility services, such as cleaning the building.

The landlord is also paying about $300/month ($3,600) for common area electric for interior halls, basement space, exterior walks, and the parking lot lighting. Water and sewer is running at about $50/unit, plus water for building uses, such as the clothes washer, cleaning services, etc.

Then, there's basic building and site maintenance for painting the apartments when a tenant moves, painting interior and exterior walls and trim, replacing a damaged door lock, light bulbs, and for exterior services, like snow removal, landscape maintenance, etc., which costs this owner about $3,600.

We've also taken a 5% expense for management services. Even though many buildings of this size are owner-managed, there are still expenses associated with management of a building, including consideration of accounting fees, permits, inspections, etc.

Finally, we've accounted for trash removal, the exterminator to come monthly, and for miscellaneous things that tend to unexpectedly pop up from time to time.

And, when we deduct these operating expenses, which total $89,794, we arrive at the Net Operating Income (NOI) of $72,086.

IT'S WORTH NOTING, that the operating expenses consume 55.47% of the Effective Gross Income and leave 44.53% as the NOI. Also note, that there have been no allowances or deductions taken for or as set-asides for the future replacement of major items such as the roof, resurfacing the parking lot, replacing the furnace, hot water heater, or unit refrigerators.

If we capitalize that NOI (convert it into a capital sum) using a 6% capitalization rate, the result is an indicated market value of about $1,200,000, rounded.

HIGHEST AND BEST USE ANALYSIS

Let's see whether or not this current hypothetical 12-unit building is the highest and best use of this property, or if there is a different use that will generate more net income and ultimately a greater overall market value value.

And, what we're going to do, is look at our hypothetical parcel of real estate as if it was a vacant lot. Then, we're going to submit that vacant lot to the required standardized tests that were stated earlier in this article. From the results of those tests, we'll be able to determine what, if any other use, may create a more valuable use that the current 12-unit apartment building.

KEEP IN MIND - THIS IS ONLY AN EXAMPLE - IT DOES NOT CONSIDER 100% OF THE COMPONENTS THAT WOULD NEED TO BE CONSIDERED IN AN ACTUAL HIGHEST AND BEST USE ANALYSIS. THAT IS BECAUSE THIS EXAMPLE HAS BEEN CREATED SOLELY FOR THE PURPOSE OF PROVIDING AN OVERVIEW AND AN UNDERSTANDING OF THE PROCESS.

TEST 1: LEGALLY PERMITTED USE(S)

When we research the zoning, we find that regulation that governs the use of our property is designated a "multi-family" zone.

In reading the ordinance, we find that the only legally permitted uses are multi-family residential apartment buildings. The regulation goes on to limit development to a maximum density of 30-units per acre on a minimum sized lot of 13,500 square feet.

There is no front-yard setback requirement, but there is a 30-foot rear yard setback (the minimum distance between the back of the building and the rear property line) and a 2½ foot side-yard setback on each side, and it limits the overall height of a building to 40 feet.

highest and best use

The zoning regulation also requires off-street parking at 1.8 parking spaces for every 1-bedroom unit, 2.0 parking spaces for every 2-bedroom unit, and 2.1 parking spaces for every 3-bedroom unit.

TEST 2: PHYSICALLY SUPPORTED

Now that we know the only permitted use of our property is for development with a multi-family apartment building with a maximum density of 30 units per acre, and knowing that the size of our parcel is 1-acre, we have to determine if a 30-unit building can fit on our lot and meet all the requirements of the zoning ordinance.

First, we have to determine what unit mix our building will have (how many 1-bedrooms, 2-bedrooms, etc.), and what size each unit type should be. We'll do this by researching the market.

And, after completing our research, we found our market area prefers 2-bedroom 2-full bath units over 1-bedroom 1½ bath units by a ratio of 2:1. We also found, the market prefers 2-bedroom units that are at least 1,000 square feet in area and 1-bedroom units that are at least 800 square feet in area.

Next, we have to determine what our new building will look like; more specifically, what shape it will take. And, knowing that building a rectangular building is less expensive than a multi-shaped building, that will be our preference.

highest and best use

So, if we follow the market's indications, we'll have 20 2-bedroom 2-bath units at 1,000 square feet each which totals 20,000 square feet, and 10 1-bedroom 1½ bath units of 800 square feet each which totals 8,000 square feet. So, we know we need to construct a building that's at least 28,000± square feet.

But, we also have to consider either interior common halls or even exterior common space f±or access to and from each unit. From our research, we find that this type of common space consumes another 15% of the building's area, which brings us to a total building area of 32,400± square feet.

So, if we have 3 floors with 10 units per floor with 10,800± square feet per floor, we can build a rectangular building that will measure 180 feet wide by 60 feet deep. Since the zoning allows us to build to our front property line and our land is about 218 feet deep, we'll have 158 feet, or 5 times the distance required by the zoning regulation between the rear of the building and our rear property line.

And, with 31,600 square feet of open space behind our building, we'll have more than enough room for the 60 parking spaces required by the zoning regulation if we calculate 2 parking spaces per unit.

ONE ADDITIONAL CONSIDERATION:
Since the zoning regulation allows a building of 40-feet high, and our proposed 30 units are only going to require 3 floors (at about 10 feet per floor), we have the ability to create a 4th level.

In fact, for design functionality and aesthetic reasons, we would built a first floor of another 10,800± square feet and would use it for a common foyer entry, a meeting/entertainment room, and a fully-equipped fitness center for tenants.

Finally, considering that all of the utilities required to serve a 30-unit apartment building are already in-place and serving the 12-unit building, there is no concern for the ability of the land and the site being able to support the development of our site with a 30-unit building.

But, the question now becomes, will this new 30-unit building provide a reasonable return on investment to justify creating it?

TEST 3: FINANCIALLY FEASIBLE

To determine the economic viability of a proposed building, we have to contrast the cost to create the building vs. the market value of that building as if completed and in place.

CONSTRUCTION COST ESTIMATE

ESTIMATING THE COST TO CONSTRUCT this conceptual 43,200± square foot, 30-unit building we have competitive estimates of $155 per square foot of the gross building area of 43,200 square feet which totals $6,696,000, rounded up to $6.7 million. We'll also add another $100,000 for the fitness center equipment and the furnishings for the meeting/entertainment room and foyer.

Then we've estimated the cost to build out our site improvements, such as the parking lot, the parking lot lighting, sidewalks, etc., which will add another $100,000.

Next, we have a quote of $50,000 to raze and remove the existing building (which also saves us a little money on our site preparation expenses for constructing the new building).

highest and best use

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Finally, we've added another $100,000 for miscellaneous and unforeseen expenses that tend to crop up.

Thus, we've ultimately rounded our estimate of $6,946,000 up to $7,000,000 just for additional padding against surprises.

MARKET VALUE ESTIMATE

Now that we know that it's physically possible to construct a hypothetical 30-unit apartment building on our site, and we also know the probable cost to create this building to completion, we now have to determine if this building, when completed and fully occupied, will provide a reasonable and competitive return to justify the investment of $7 million to create it. 

When we did our market research, we found that 2-bedroom 2-bath units in newer buildings in our market area are renting for between $2,100 and $2,300 per month with the tenant paying all of their own utilities, except for water and sewer.

To play it safe, we're going to charge $2,200 per month for our 2-bedroom 2-bath units, and we'll pay the water and sewer charges.

Our research also found that 1-bedroom 1½ bath units in newer buildings in our area are renting for between $1,700 and $1,900 per month with the tenant paying all utilities, except for water and sewer.

Again, to play it safe, we're going to charge $1,800 per month, and we'll also pay the water and sewer charges.

Additionally, in other buildings in our market, tenants get only 1 parking space per unit; if they want a second space, they're charged an additional $120 per month. We also discovered, that about half of all tenants in our area have 2 cars.

So, because street parking is not allowed in our location, we can estimate that we'll probably rent 15 parking spaces at $120 per month. This leaves the remaining 15 spaces for visitors.

We've subsequently estimated that we'll gross $216,000 for the 21-bedroom units, $528,000 for the 2-bedroom units, and another $21,600 for the 15 parking spaces bringing us to a total income of $765,600 at 100% occupancy.

Assuming the same 95% occupancy rate as we did for the 1970s 12-unit building, we will have an effective gross income (EGI) of $727,320.

Deducting our estimated expenses based on the size of our building, and allowing savings on the cost of heat and hot water that tenants now pay for themselves, and adding the additional expense of a higher water and sewer bill, higher cost of trash removal and exterminator, as well as considering the same 5% management expense, our total operating expenses come to $259,326, which is 35.66% of our effective gross income. 

highest and best use

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This is a significant savings compared to the 55.47% for the expenses on the 1970s 12-unit building.

This leaves a net operating income (NOI) of $467,944, or 64.34% of the effective gross income; a major increase over the 44.53% NOI in the 1970s 12-unit building.

When selecting a capitalization rate, we have to consider the facts that, 1) this 30-unit building will be a brand new building, 2) it's risk of ownership has diminished due to the increased number of units, 3) it will have no functional obsolescence since it was built to satisfy current market demands and trends, and 4) its NOI is almost 45% higher than the NOI generated by the 1970s 12-unit building.

Consequently, because of the significant benefits of the proposed 30-unit building over the existing 1970s 12-unit building, we decide that a 5% capitalization rate is justified as compared to the 6% capitalization rate we selected for the 1970s 12-unit building.

And, after capitalizing our NOI, we have a market value indication of $9,360,000. And, after deducting the $7 million to create the new 30-unit building, the remaining $2,360,000 equity provides a 33.71% return on our $7 million investment.

We should note, that the ROI just the creation of the 30-unit building is virtually twice the total value of the 1970s 12-unit building.

OPINION OF HIGHEST AND BEST USE

When contrasting the higher amount and percentage of the NOI in the proposed 30-unit apartment building compared to the existing 1970s 12-unit apartment building, plus the benefits of a new, modern building and the substantially lower risk and higher levels of value and equity in the proposed 30-unit apartment building, it's our opinion, that the highest and best use of the real estate which is currently improved with a circa 1970s 12-unit apartment building is for that building to be razed and that a new 30-unit apartment building as described in this analysis be constructed on that site.

What say you now ...?

So, as the owner of that 1970s 12-unit building who thought you were doing well, by doing this example of a highest and best use analysis, I've just shown you that you're leaving nearly $400,000 a year of net operating income on the table along with about $8 million in value.

This example doesn't mean that every property owner is going to realize a benefit similar to the one contained in this example. However, there are actually many owners who have no idea of the substantial amount of financial rewards they are missing the benefit of by failing to hire a competent real estate analyst (like me 😊 ) to perform a highest and best use analysis of their property.

Who Else Can Benefit from a Highest and Best Use Analysis?

Owners aren't the only people who can benefit from a highest and best use analysis.

Real estate agents hired to sell property have a fiduciary duty to get the highest price possible for their seller clients. And, it's impossible to know the highest price for a property unless they know its highest and best use. That also goes for agents who represent buyers, so they can provide their clients full knowledge of the value of the property they may be interested in buying ... or, the property they may otherwise overlook.

Then, there's the lender, the real property tax assessor, the bankruptcy trustee, the IRS, the divorce lawyer, the estate planner, and so on, and so on, and so on.

In conclusion, it's certainly reasonable to say, the virtually every person and entity that has an interest in knowing the market value of a parcel of real estate - no matter what type of real estate it may be - is likely to benefit from the results of a highest and best use analysis.

One of my professional services includes performing highest and best use analyses. Contact me even if you only wish to discuss this issue.

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