Highest and best use to a lay person is nothing more than the individual's personal opinion concerning how a parcel of land should be best used. But to a valuer or property specialist the highest and best use of a property will determine what that particular property is worth. Its use must meet a series of four tests:
(1) Test of Physical Possibility
Consideration must be given to the size and shape of the land parcel, its terrain, road access, subsurface conditions, presence of environmental constraints (such as fauna and flora preservation) and contamination from prior use.
(2) Test of Legal Permissibility
Local, state and federal government have laws and regulations that control the use of land. The only permissible uses of the land are those that are permitted by these laws and regulations. In addition to zoning restrictions, the use might be restricted by issues such as those pertaining to heritage listing, native title, road alignment, flora and fauna.
(3) Test of Financial Feasibility
Does the return on investment (ROI) or profit from the proposed use meet the developer's requirement? The proposed use must achieve the target ROI or profit for the developer to justify the costs of construction, and bearing the risks related to the development.
(4) Test of Maximum Productivity
For this test, it is a matter of selecting the use that provides the highest ROI or profit.
Simple Example of Highest and Best Use
Built on a 905 square metre site is a single storey detached house in reasonable condition which is currently used as a residence but includes some office and storage use.
Zoning regulations allow for the continuing use as a residential property, use as an office or storage area or the development of a light industrial use. These are the only uses considered to be possible and probable.
The value of the property is then estimated assuming different allowable uses. The results are as follows:
Use No. 1: Value as House
Value Estimate $510,000 (based on Sales Comparison)
Net Income $23,400
Net Income Multiplier 22 or 4.55% Rental Yield
Value Estimate $514,800 (based on Rental Income)
Use No.2: Value as Office
Net Income $50,000
Net Income Multiplier 13 or 7.69% Rental Yield
Value Estimate $650,000 (based on Income Approach)
Use No.3: Value as Vacant Industrial Site
Site Area 798 sq.m
Land Value Rate / sq.m $600
Value Estimate $478,800
In this example the Highest and Best Use of the property is as an Office ($650,00 versus $514,800 as House and $478,000 as Vacant Industrial Site).