Focus on real estate analysis: comments on the concept and definition of highest and best use.

HIGHEST AND BEST USE ANALYSIS DOES NOT APPLY SOLELY to appraisals; it also relates directly to real property market analysis. Appraisal literature may contain the majority of discussion and presentation of HBU analysis to date, but it is imperative to valuation methods that all types of real estate practitioners rely on.

The 2001 edition of The Appraisal of Real Estate provides three definitions for HBU: (1)

* General definition -- The reasonably probable and legal use of vacant land or an improved property that is physically possible, legally permissible, appropriately supported, financially feasible, and that results in the highest value.

* For vacant land -- Among all reasonable, alternative uses, the use that yields the highest present value after payments are made for labor, capital and entrepreneurial coordination.

* For improved property -- The use of a property, as improved, that will maximize its value.

This general HBU relationship among legally permissible, physically possible and financially feasible can be depicted as a simple Venn diagram (see Figure 1). Each circle represents one of the three elements. (2) In this context, financially feasible must be defined in some clear and definite context. It could be all properties that generate a positive net present value at the investor's anticipated or required rate of return; the discount rate that meets the investor's financial needs; or an internal rate of return that surpasses a predetermined hurdle reflecting the investor's perceptions of a safe rate, risk premium, illiquidity premium and administrative/management cost.

The intersection of the three elements can contain several different land uses for the property. To find the maximally productive option, the practitioner must identify the use in the intersecting area with the highest return--the use that has the best outcome when put to a financial test or guideline.

THE LENNHOFF AND PARLI CRITICISM

Researchers have raised several concerns about the definition of HBU. One article by David C. Lennhoff and Richard L. Parli states the current HBU definition is "both ambiguous and redundant." (3) Their concerns refer to the phrase "reasonably probable and legal use." The phrase is ambiguous because it "suggests that only currently legal uses that are reasonably probable be considered." They continue: "Reasonable probability is both a tentative starting point and a conclusion if the use or uses that are ultimately deemed probable." The test, they say, is the use that is ultimately probable.

[FIGURE 1 OMITTED]

Lennhoff and Parli offer a new definition for highest and best use: "The probable use of land or improved property specific with respect to user and timing of the use that is adequately supported and results in the highest present value."

This article advances the Lennhoff-Parli critique. Their new definition moves in the right direction, but is also subject to evaluation, constructive criticism and reformulation.

First, the term "probable" should be replaced with a more explicit phrase such as "current or future" or "existing or prospective," which represent fact instead of conjecture. Second, the term "adequately supported" is too weak and vague. Practitioners can interpret it as "just scraped by" or "just made it over the hurdle." It also fails to answer the question: Adequately supported by what? Adding the adjective "financially" makes the nature of the support clear. Furthermore, if it is just adequately supported, why should it generate the highest present value?

The definition should use the term "financially feasible" because it is the basis of the HBU test. Thus, an alternative definition for vacant land and improved property is:

* HBU is the current or future use of vacant land specific with respect to the user and timing of the use that is financially feasible and results in the highest present value to the land.

* HBU is the current or future use of the improved property specific with respect to the user and timing of the use that is financially feasible and results in the highest present value to the property.

This recalibrated definition suggests a very important change. The issues of legal permissibility and physical possibility do not appear. Instead, the definition relegates legal permissibility and physical possibility requirements to inferior positions relative to financial feasibility. It places greater emphasis on the analyst's or appraiser's expert judgment about a use to be developed in the future.

FINANCIAL FEASIBILITY ISSUES

Financial feasibility involves two underlying issues. The first is specifying the phrase in an unambiguous manner. The second is ensuring a free market environment where no particular agent or entity is able to manipulate a property's financial feasibility.

The financial feasibility test is a critical element in HBU analysis. It needs to be clear, complete and as concise as possible. However, Lennhoff and Parli argue that ambiguity exists around the concept of financial feasibility. They make their point by considering two definitions found in Appraisal Institute publications:

* Financial feasibility is one of the four criteria the highest and best use of a property must meet: the ability of a property to generate sufficient income to support the use for which it was designed. See also economic feasibility. (The Dictionary of Real Estate Appraisal)

* As long as a potential use has value commensurate with its cost and conforms with the first two tests (for HBU), the use is financially feasible. (The Appraisal of Real Estate)

Yet considering only current market conditions is ambiguous and incomplete. The Principal of Anticipation tells us that current market value comes from future benefits, not the present or past. Following are the other definitions related to financial feasibility that appear in the appraisal literature.

* Feasibility analysis is a study of the cost-benefit (cost-revenue) relationship of an economic endeavor. (The Appraisal of Real Estate)

* Economic feasibility is the ability of a project or an enterprise to meet defined investment objectives: an investment's ability to produce sufficient revenue to pay all expenses and charges and to provide a reasonable return on and recapture of the money invested. In reference to a service or residential property where revenue is not a fundamental consideration, economic soundness is based on the need for and desirability of the property for a particular purpose. An investment property is economically feasible if its prospective earning power is sufficient to pay a fair rate of return on its complete cost (including indirect costs), i.e., the estimated value at completion equals or exceeds the estimated cost. (The Dictionary of Real Estate Appraisal)

* Economic feasibility analysis is an analysis undertaken to investigate whether a project will fulfill the objectives of the investor. The probability of a specific real estate project is thus analyzed in terms of the criteria of a specific market or investor. (The Appraisal of Real Estate)

* Economic feasibility analysis may be defined as an investment's ability to produce sufficient revenue to pay all expenses and charges and to provide a reasonable return on and recapture of the money invested. (The Appraisal of Real Estate)

* Economic feasibility is indicated when the market value or gross sellout of a project upon achievement of a stabilized condition equals or exceeds all costs of production. Market value applies to a planned rental property: gross sellout applies to a project that will be developed as multiple units to be sold to multiple users. (The Appraisal of Real Estate)

After reading these definitions of financial and economic feasibility, the need for a clear, complete and concise definition for these two concepts is obvious. Practitioners might infer that "economic feasibility" and "financial feasibility" are synonyms. They also might get the impression two dimensions to feasibility analysis exist. One deals with costs (operating costs and debt service) and returns (investment analysis); the other concerns value (market valuation) vs. cost (development and construction costs).

Appraisal literature needs to settle on one or the other phrase--financial or economic feasibility. Financial feasibility carries more weight because it is a test in HBU analysis. The term can cover two aspects in its definition:

* Financial feasibility analysis investigates the ability of a real property equity investment to produce sufficient periodic revenue (effective gross income) to pay all expenses (operating costs and debt service) and a future period reversion (sales price less selling costs and the loan balance), and to provide a return on investment that entices the investor to acquire the property and recapture the money invested.

* Financial feasibility analysis investigates the ability of a real property equity investment to generate a market value that equals or exceeds the full cost of construction and development (direct and indirect costs) of the property.

These two considerations of financial feasibility analysis are related: The yield capitalization of the net operating income using the appropriate terminal capitalization rate in the appropriate manner, and the appropriate discount rate establishing the current market value of the investment.

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