Highest and Best

Highest and Best Use (often shortened to “Highest and Best”) is a core concept in Real Estate Appraisal that determines the most profitable and efficient use of a property. It’s not about the current use of a piece of land or a building, but the potential use that would create the most value. Think of it as finding a property's hidden superpower. This theoretical “best” use must meet four strict criteria: it must be legally allowable, physically possible, financially feasible, and result in the highest possible value. For an investor, understanding this concept is like having X-ray vision; it allows you to look past a company's struggling operations and see the true, unlocked value of its underlying assets. This perspective is fundamental to Value Investing, as it helps uncover assets that the market has mispriced based solely on their current, often suboptimal, function.

For a potential use to be considered the “Highest and Best,” it must pass a series of four tests in order. If a use fails any test, it's immediately disqualified.

This is the first hurdle. Any potential use for a property must comply with all government regulations. The most important of these is typically Zoning law, which dictates what can be built in a certain area (e.g., residential, commercial, industrial). Other legal constraints include building codes, environmental regulations, and private restrictions like deed covenants.

• Example: You might own a beautiful, large plot of land, but if it's zoned exclusively for single-family homes, its “highest and best use” cannot be a 20-story office tower, no matter how profitable that might seem.

If a use is legal, the next question is: can you actually do it? This test considers the physical characteristics of the property itself.

• Key Factors:
  • Size and shape of the land
  • Topography (is it flat or on a steep hill?)
  • Accessibility (is there road access?)
  • Availability of utilities (water, sewer, electricity)
• Example: Building a massive distribution warehouse is physically impossible on a tiny, oddly shaped plot of land with no road access, even if it's legally permitted.

A use might be legal and physically possible, but does it make economic sense? To pass this test, the expected income from the proposed use must be greater than the costs to build and operate it. A use that would lose money is not feasible.

• Example: Building luxury condos in a neighborhood with very low property values might be legal and possible, but if the construction costs exceed what people are willing to pay for the finished units, the project is a financial non-starter.

This is the final and deciding test. From the pool of uses that have passed the first three tests, which one generates the highest financial return or Market Value? The winner is crowned the Highest and Best Use.

• Example: After analysis, a plot of land is found to be suitable for either a gas station or a small apartment building. Both are legal, possible, and feasible. An Appraisal concludes that the apartment building would generate a net return of $500,000, while the gas station would generate $350,000. Therefore, the apartment building is the maximally productive use.

The concept of highest and best use is a powerful tool for finding hidden value, which is the bread and butter of value investing. A company's stock price often reflects the value of its assets in their current use, which may be far from optimal. A classic value investing play involves finding companies whose real estate assets have a higher and better use than the one they're currently being put to.

• The Hidden Gem: Imagine a struggling big-box retail company. The market punishes its stock because of poor sales. But what if the company owns, rather than leases, its hundreds of stores located on prime commercial land? A savvy investor analyzes the Real Estate portfolio and realizes its value, if redeveloped for other purposes (like mixed-use residential and commercial hubs), is far greater than the value of the entire company as a retailer. The company's stock is cheap based on its failing business, but it's a bargain based on the highest and best use of its assets. This provides a significant Margin of Safety.

This mindset extends beyond real estate. It's about analyzing all of a company's assets—brands, patents, divisions, customer lists—and asking, “Is this asset being put to its highest and best use?” If the answer is no, you may have found an opportunity that the rest of the market has overlooked, allowing you to estimate an Intrinsic Value far greater than the current stock price.