Valuation Management Group, as an appraisal management services company, serves its lender clients by reviewing residential and commercial appraisals prepared by independent appraisers. Appraisal reports must address the subject property’s Highest and Best Use (H&BU) by analyzing the subject’s potential uses with these four tests: Is it (any given potential use) legally permissible, physically possible, financially feasible, and maximally productive? Only the test of financially feasibility (for the site As Vacant) is being addressed today. As our reviewers periodically see this test misapplied, we share the following information for the benefit of our clients and appraisers in hopes that any potential errors can be avoided.
Questions to be explored by the appraiser in analyzing the H&BU include:
- Can an investor/developer on a speculative basis buy the site, construct the legally permissible and physically possible use(s), and make an appropriate profit? If not, then that use or those uses are not financially feasible.
- Using the land residual technique, which use would produce the highest land value? What does it cost to construct a commercial use, retail, office or industrial use, including an appropriate profit? What rents does the market show? What vacancy rate would be appropriately expected? How long would it take to achieve stabilized occupancy? What would market-based expenses be? What cap rate would the market apply?
- What if the market would only allow for a 5% profit in the development of a certain use, when the market norm is a 15% profit? That would not pass the test as it would not be financially feasible in this context.
- What other speculative developments have been built in the area of the subject. If nothing, then it is not likely that the demand for new product is present. Thus, that specific legal and possible use would not be a financially feasible use.
- What about owner-user developments? Do these indicate financial feasibility? Not necessarily. Bobby Business Owner can build whatever he wants, as he is not driven by the same motive as the spec builder. For the owner-user (or other build-to-suit scenarios) the cost approach does not reflect market value, but rather a value specific to that owner in that specific use.
- Therefore, if in the surrounding area, there are only owner-user properties and no commercial speculative properties, it would not likely be financially feasible to develop commercial uses. Thus, such uses would not pass this test.
- What if the Prospective Value Upon Completion of a proposed industrial building is $300,000, but it’s going to cost $400,000 to construct it? Would that use be financially feasible? Obviously, losing $100,000 upon completion is not profitable and therefore not financially feasible.
- What are the predominant land uses in the area? Is there any evidence that the market is transitioning away from its historical, typical use to something else? For example, SFR uses on a now-busy thoroughfare often are seen transitioning from a residential H&BU to some form of commercial H&B, often as office or retail. A change in zoning often presages or coincides with this transition.
- A final appropriate question the appraiser should ask is, “Does it make sense?” In a rural area miles away from the nearest rural town, with almost nothing but agricultural acreages, undeveloped wooded tracts and a scattering of SFR uses, does it make sense that the H&BU would be commercial? Not likely!
- On most residential appraisals with a dwelling in place, the highest and best use is quickly determined as residential and no formal, step-by-step analysis is required. However, in instances where commercial uses are in close proximity and there may be several former residential uses that have already transitioned to commercial, a step-by-step highest and best use analysis would be necessary and appropriate for the subject property.
Valuation Management Group is a national, full service appraisal management service company that manages the appraisal process, including the required review, for financial institutions, banks, mortgage bankers, and credit unions. We offer the full array of commercial and residential appraisal products and services, taking the appraisal process from ordinary to extraordinary.