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Highest and Best—and the Highest Value
by Richard Hagar, SRA
Do you want to make everybody happy in a real estate purchase and finance transaction? If so, then the appraisal’s value conclusion needs to come in at the highest value possible. Sellers are happy because they receive money. Lenders and mortgage brokers are happy because they have a large loan amount, and agents are happy because they receive a lofty commission based on the high price.
That being said, an appraiser’s job isn’t to value a property at its purchase price. Our job is to provide an accurate description of the market and subject property together with a market value conclusion properly supported by market data.
Market value is the price most potential buyers would pay for a property not the price an individual person would pay. Market equates to majority. There are appraisers out there who incorrectly state that they value property based on what a buyer is going to do with the property. In their view, if there’s an Accessory Dwelling Unit (ADU) on the property and the buyer isn’t going to rent it out, then they fail to determine the ADU’s rental income or give the unit lesser value. If there’s an end-of-life single-family home on a site zoned multifamily, but the buyer plans on living in the house, some appraisers incorrectly value the property as an SFR, ignoring the multi-family zoning. That example doesn’t result in market value, it determines the value for an individual buyer, based on their intentions. That’s not how this process works. It doesn’t matter what an individual pays for a property, an appraiser’s job is to support what the market would pay for the property, hence the term “market value” which leads to: the Highest and Best Use Analysis and its impact on achieving the highest value.
When I started appraising, I didn’t always pay close attention to the Highest and Best Use Analysis; why would I? The site was zoned single-family residential (SFR), the subject was an SFR, so check the box on the form, move on, and where’s my check? Unfortunately, back then I didn’t know what I didn’t know, working through the process of becoming an SRA with the Appraisal Institute (AI), I found out that I may have been doing things incorrectly—oh the shock and horror, but it does happen. In going through AI classes, I learned that the Highest and Best Use Analysis is the basis for properly determining the market value of a property. Without the analysis, the appraisal’s stated value conclusion is often an incorrect guess. The class taught me that the analysis helps examine the actions of the market, determine land value, depreciation & condition adjustments, and the contributory value of the improvements built on the site, all based on the actions of most buyers and sellers.
The Highest and Best Use Analysis is so important that students must take a thirty-hour class on the topic, a thirty-hour class on the site and cost approach, plus a sixty-hour class on the income approach before sitting down to take the test to become a Certified General appraiser—of which there’s a 50 percent failure rate.
Today’s value for a property is based on its future use or potential uses. How much would a property be worth if it could only be used for one day? Conversely, if a property could be used for 100-plus years, it would have a higher value. Most people would pay more for a property if they knew trees impacting a view are scheduled to be cut down, revealing an ocean view where none exists today. In other words, some of today’s value is tied to potential future uses including changes in the economy or a change in zoning. The more positive potential future components are, the higher the value today. This is why knowing what’s legally possible impacts today’s value.
Let’s break down the words “highest and best” and examine their impact. A proper analysis looks at the market and tries to determine what is the best current use and potential future uses that create the highest value today. Oddly enough, most appraisers do this all the time, we just don’t think of it in our daily work.
The starting point for achieving a high value is determining a property’s legal use. For most appraisals, the appraiser is not supposed to give value to illegal or prohibited uses, so we look at zoning for guidance. At this point, it doesn’t matter what improvements are on the site, the question is: what does zoning allow to be constructed on the site? The appraiser is trying to determine the highest value for the land; and that requires understanding the site’s legal use today and in the foreseeable future. Next, determine how much more the structure built on the site adds to the land value. The highest land value combined with the contributory value of the most ideal improvements produces the highest value conclusion; something that, you hope, will keep everybody happy.
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The analysis is a two to three-step process:
1. Based on the legal or potential legalities and physical constraints, which of the potential uses results in the highest value for the site as if it were vacant?
2. Then, what type of building or improvement would add the greatest value to the site? Steps one and two should point to the use and structure that produces the highest value.
3. However, what if there’s a building on the site? How does the building match the theoretical highest valued structure for the site?
The highest land value combined with the highest building value should produce the highest total value. Unfortunately, not every lender likes the conclusion or the box the appraiser must check if things don’t ideally align.
Let’s work through two examples. Take a site zoned commercial in a city that only allows commercial uses in a small area. While someone could build a house on the site, the house typically wouldn’t add the greatest value. However, if someone were to add a coffee shop or commercial building to the site, the commercial improvement would likely contribute more value than a home. In other words, matching the ideal improvement to the underlying zoning likely produces the highest value.
How about a site that is zoned multi-family but there is a small, older single-family home on it? If prices are increasing and there’s high demand for more living units would a single living unit or multiple living units produce the greatest increase to the property’s income production and value? Often, multiple living units would increase the property’s value the most. If so, then how does the existing single home fit the ideal improvement for the site? That is the question every appraiser must answer in a Highest and Best Use Analysis, as required by the Standards:
Standard Rule 1-3.
When necessary for credible assignment results in developing a market value opinion, an appraiser must…
b) develop an opinion of the highest and best use of the real estate.
In the above example the SFR is not the ideal structure because it’s mismatched with the maximum number of units allowed by zoning. While it may add something to the value, it is not the ideal building that increases the property’s value the most, however, a multi-family building would.
Therefore, the SFR building is likely economically and functionally an obsolete structure (the appraisal term is economic and functional obsolescence).
Attempting to accurately ascertain value is why appraisers ask:
A. What are the legal uses for the site?
B. What is physically possible for the site?
C. Is there market demand for what can be built on the site?
D. Which potential use and building would produce the highest property’s value?
Knowing the land value, as if vacant, helps determine the contributory value of an existing structure. The structure’s value will lead to determining the remaining economic life, depreciation rates, condition adjustments, as well as site adjustments between the subject and comparables. The best comparables should have the same highest and best use as the subject, which in turn produces the highest value with the fewest adjustments.
In a Highest and Best Use Analysis, the term analysis encompasses both steps: the land as if vacant (even if it isn’t) and an analysis of an existing or proposed structure on the land. If all an appraiser does is analyze the existing structure as improved, then they are only performing half of what’s required. Way back when, USPAP outlined both steps (as if vacant and as improved) and the term analysis. However, that was redundant, so they dropped the terms “as if vacant” and “improved” and replaced them with the term “analysis” since that incorporates both steps. Mark Ratterman’s book, Residential Market Analysis and Highest and Best Use, classes by the Appraisal Institute, and classes at OREPEducation.org also explain the two or three-step process.
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As Improved
Many appraisers indicate that Fannie Mae “only” wants to know the highest and best “as improved” but that again is only half of the story. First off, the typical appraisal form is not USPAP compliant; appraisers must perform additional analysis and add additional information to produce a compliant appraisal. For years, I’ve stated that appraisers should be adding information and analysis regarding the site in addition to the check box on the front page of bank appraisal forms. This is a truncated version of what we have in our addendums:
Based on my analysis of the neighborhood, market demand, and zoning, the highest and best use of the site as if vacant is for a single-family residential home. The highest and best use of the existing improvements is that of a single-family home with demand for this use, by an owner occupant, being now, as indicated on the front page of the form.
(Our full version takes up half of a page or more.)
Many appraisers only know of the first part of Fannie Mae’s guideline, but the second part is very informative:
The mortgaged premises must be:
The highest and best use of the property as improved, and the use of the property must be legal or legal non-conforming use.
Now, here is the second part that many appraisers miss:
• For improvements to represent the highest and best use of a site, they must be legally permitted, financially feasible, and physically possible, and must provide more profit than any other use of the site would generate.
• All of those criteria must be met if the improvements are to be considered as the highest and best use of a site.
• If the current improvements do not represent the highest and best use of the site … it must be indicated on the appraisal report. (B4-1.3-04, Site Section of the Appraisal Report)
Going back to the multi-family zoning example: If there’s a small older house on a multi-family zoned lot, does the small home provide more profit (or increase in value) than a new multifamily building would? An appraiser shouldn’t skip over this question or step when analyzing the property. The appraiser must analyze market demand and the property to determine a home’s relationship to how much it contributes to a property’s total value.
Unfortunately, if market demand or zoning changes, the existing home might not represent the most profitable use of the site. This is where some lenders start to loath a thorough analysis. It doesn’t matter if a loan is being sold to FNMA or not. FNMA, Freddie Mac, FHA, VA, and FarmHome all require appraisals to comply with USPAP, so even if there’s conflicting information in the guidelines or what other appraisers try to tell you, you must follow USPAP.
When Zoning Changes
There are a few areas that are upzoning to multi-family. When zoning changes, the existing structure might not be the one that contributes the most value today. The existing house could even be a detriment due to the costs of tearing it down and carting it away. Even if the house remains, what is its contributory value?
Here’s a recent example from my area. Assume the house contributes $50,000 to the total value (Land is worth $300,000 the house contributes $50,000 for a total of $350,000). The question is, if a builder buys the property and tears the house down (sacrificing $50,000) would building a new structure that meets the new zoning code then selling it, provide more profit to the builder than $50,000?
In my example the new multi-family building (or multiple townhouses) sold for $2,000,000. The builder’s profit was 15 percent, which is typical. That means the builder’s profit was $300,000 or $250,000 net, after tossing away the old house. Hmm, buy a house, tear it down and you can obtain a net profit of $250,000. Doesn’t take a genius, or even a competent appraiser, to figure out what type of building, added to the site, produces the highest value. Even if the old house contributed $100,000 to the value, future profits far and away exceed that figure. This is the rudimentary analysis appraisers should perform before simply checking the Highest and Best Use (H&BU) “As-Improved” box on the front of the form.
This is also why the H&BU analysis requires appraisers to look around the neighborhood and determine what is happening today and will likely happen in the future. Supply and demand are important parts of the analysis which will inform the appraiser and lender on how long the house will likely remain before it’s torn down (components of economic life and effective age).
The Highest Value
Unfortunately, there are lenders out there that don’t want a proper analysis or the highest value, they just want an appraiser who will check the box and give them the value they desire. They also look at appraisers as disposable pawns in the lending game. They find the cheapest, the easiest to push around, and if something goes wrong, they duck and let the appraiser take the hit.
Producing the highest value usually requires knowing the best use for the land and determining which structure would increase its value the most. There are many clients out there willing to pay lucrative fees for appraisals with a proper analysis; besides, it’s something competent appraisers do every single day.
My suggestion: take several classes on Highest and Best Use. I also have a two-part webinar on WorkingRE.com that will help, called “Land Value and the Cost Approach.” Become better educated than the box checkers who may become a future target.
I’m trying to keep you safe out there.
About the Author
Richard Hagar, SRA, is an educator, author and owner of a busy appraisal office in the state of Washington. Hagar now offers his legendary adjustments course for CE credit in over 46 states through OREPEducation.org. The 7-hour online CE course “How to Support and Prove Your Adjustments” shows appraisers proven methods for supporting adjustments. OREP Members save on this approved coursework. Sign up today at OREPEducation.org. Reach Richard Hagar via email at rh@richardhagar.com.
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