Commercial real estate appraisals must consider the property's "highest and best use" in relation to valuing the property appropriately. This is because the highest and best use determines the most profitable use of the site, whether vacant land or an existing income producing property.
The Fifth Edition of The Dictionary of Real Estate Appraisal by the Appraisal Institute defines highest and best use as: 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. An appraisal report should include the information and facts used to support their summary and opinion.
An important part of a good appraisal report is for the appraiser to understand the market area surrounding the property.
There are four tests to determine highest and best use: 1, is it legally permissible, 2, is it physically possible, 3, is it financially feasible, and 4, is it the most profitable use of the site?
- Legally Permissible.
Most of the concern for legality lies with the zoning of the site and any building or municipal codes or standards for the property. Some cities have minimum and maximum building sizes depending upon the size of the lot. There also may be easements or encroachments to allow for driveways or maintenance of roads, utilities, etc. A survey will need to be performed so that all such easements are taken into consideration during the appraisal process.
- Physically Possible
The appraiser will examine the physical characteristics of the site including the acreage or square footage, shape of the boundaries, topography or the rises and falls of the landscape and accessibility to public roads. These characteristics will be fully described in the appraisal report and will help determine the maximum size building and parking that will fit on the lot.
- Financially Feasible
Financially feasible may also consider whether the property is economically feasible. This pertains to the highest and best use as if vacant. Again, it is important to know the surrounding properties. If the proposed property would be an average office building, more than likely, it would not be financially feasible to build a luxury office space that plans on including many high-end extras, because that would create an over-improvement.
Also, using the information gathered from the physical characteristics of the site will help determine the financial feasibility of the proposed project. For example, if the lot is not level the cost of fill dirt and a retaining wall will need to be calculated.
- Most Profitable Use
The bottom line is what would be the highest net income for the proposed project. Determining the most profitable use might require a market analysis or a feasibility study. Some appraisers may include this in their report, and some may not. It is important to go over the scope and depth of the appraisal when vetting appraisers.
A commercial appraiser valuing a vacant commercial lot on a corner of a busy intersection needs to consider what type of commercial property should be built and its most profitable use. For a commercial appraiser, the highest and best use conclusion is more specific as to the type of improvement that should be built (retail, office, fast food restaurant, service station, etc.). Again, this would require an analysis of the net operating income for each potential building that can be legally and physically constructed on the site.