What Exactly is Highest and Best Use?

First of all, if there is one thing Highest and Best Use is not, that is exact. But we’ll get to that  later. Briefly, in the context of professional valuation, Highest and Best Use is the use that  results in the highest return to the land value. Simple enough, right? Not really. 

But let’s get the foundation laid first. The appraisal process can be broken down into three parts.  The first part is a site visit and conducting a survey for information about the subject property.  The second part is the consideration of Highest and Best Use. The third part is the research and  analysis that goes into the formation of an opinion of value. The Highest and Best Use considers  the information gathered about the subject property and results in a conclusion that establishes  the basis for the valuation. It is sometimes referred to as the bridge between the first part and the  third part of the process. 

In order to be considered the highest and best use of a property, that use must be legally  permissible, physically possible, financially feasible, and resultant in the maximally productive  use for the site. These are the “tests” for Highest and Best Use. They also serve as an outline for  the Highest and Best Use analysis.  

For a use to be legally permissible, it must conform to zoning and building codes. For example,  a commercially zoned parcel might be developed as retail or office or restaurant or housing or – increasingly – a combination, a mixed use. All of these uses must be considered. Further, the  use must be consistent with building codes and any other governmental guidelines and  restrictions. Design criteria outlined in the El Pueblo Viejo District that encompasses most of  downtown Santa Barbara would be an example of government guidelines that must be  considered.  

For a use to be considered physically possible, it must be a use that can be accommodated by the  site. Constraints on that use could include the size and shape of the site, the topography of the  site, drainage, soils, and more. An example of a physical characteristic that could impact use is  shape. A rectangular or square shaped parcel can accommodate most uses. On the other hand, a  long narrow parcel, or a triangular parcel, could result in significant limitations on use.  

For a use to be financially feasible, the cost to develop the property to the use must be at least  offset by the value. For example, assume a site has a value of $500,000 and the cost to build a  2,000 square foot home on the site is $1,000,000. The value of the property after development  must be at least $1,500,000 for the use to be deemed financially feasible. On the other hand,  assume the site had irregular topography which caused the construction cost to increase to  $1,200,000. With no change in value, the use becomes not feasible.  

Finally, for a use to be maximally productive, it must be the use that generates the highest return  to land value. Each of the tests discussed above narrow the list of potential uses. None the less,  there are still alternatives. The fourth test is intended to narrow the list to one use. For an  example, let’s build on the above-mentioned scenario. Let’s say the value generated by the total  of the above site value and construction cost is $1,700,000. This would suggest a return to the

land value of $200,000. Further, let’s assume that an alternative development scheme would be  to build a 3,000 square foot house at a cost of $1,500,000. And, let’s say the resultant value  would be $2,100,000. This would suggest a return to the land value of $100,000. In this  example, the most productive use of the site, the “Highest and Best Use”, would be the more  modest development scenario. See the chart below for clarification. 

Land Value	Improvement   Costs	Total Costs?	Value	Feasible?   (Return to the   Land)
$500,000	$1,000,000   (2,000 SF home)	$500,000 +   $1,000,000 =   $1,500,000	$1,700,000	$200,000
$500,000	$1,200,000  (2,000 SF home  with irregular   topography)	$500,000 +   $1,200,000 =   $1,700,000	$1,700,000	$0
$500,000	$1,500,000  (3,000 SF home)	$500,000 +   $1,500,000 =   $2,000,000	$2,100,000	$100,000

Of course, the above is an oversimplification. Highest and Best Use might be exact in concept  but in practice, it is more nuanced. There are many elements that are not allowed for in the  above examples. It could be that the cost to build the larger home would be somewhat lower on  a price per square foot basis due to the economy of scale. It also could be that there would be a  third alternative that might generate an even higher return.  

And finally, in a general sense, it is just not reasonable to presume that an appraiser, without an  extensive investigation and analysis, could pick the single most productive use for the site. For all the above reasons, some appraisers prefer to use the term “Reasonably Productive Use” for  

the site. And that use is assumed to be equivalent to the Highest and Best Use or the purpose of  the valuation.

What is an MAI Appraisal?

There is no defined “MAI Appraisal”. Some think of it as an appraisal report of a certain  format. Others might say it is a valuation carried out adhering to particular standards. Finally,  some think it refers to a valuation and report completed by an appraiser with the MAI  designation. Of the three, the third comes the closest to being accurate.  

The MAI designation was established almost 100 years ago by the American Institute of Real  Estate Appraisers (precursor to the modern-day Appraisal Institute). The Institute and the  designation were a response to the impacts of the Great Depression and the emerging  recognized need for objective and professional assistance in evaluating real estate. The early  leaders of the Institute looked to the Royal Institution of Chartered Surveyors in Great Britain as a model for a professional appraisal organization. The Institute refined professional  standards for appraisal practice, developed a Code of Ethics, and established requirements for  professional membership. The MAI designation originally identified a person as being a  “Member of the Appraisal Institute”. From the beginning earning the designation required a  combination of education, experience, and peer review. It quickly became seen in the legal,  financial, governmental, and accounting communities as the “gold standard” in professional  valuation and appraisal.  

With the passage of time, a certain style of reporting emerged among MAI appraisers. It was  narrative in format and divided into sections that included the premises of the appraisal, a  description of the property, and a discussion of the valuation. While it was never defined in  any formal way as an MAI Appraisal, it was often identified as such by users of appraisal  services. The basic underlying outline of the report is seen in narrative reports to this day.  

Today, appraisers in the United States are governed by the Uniform Standards of Professional  Appraisal Practice (USPAP), a document published by the Appraisal Foundation and  recognized by the Appraisal Subcommittee of the United States Congress. All state licensing  agencies (e.g., Bureau of Real Estate Appraisers in California) are required to adopt USPAP as  the applicable standards for professional appraisal.  

The first standard of USPAP is focused on developing an opinion of value. The second  standard is concerned with reporting the results of the valuation undertaking. While, in practice,  an appraiser may be working on the report as the valuation progresses, the valuation and report are recognized as separate.  

Standard 2 of USPAP is subtitled, “Real Property Appraisal, Reporting”. There is no required  format for an Appraisal Report. However, Standard 2-1 does include General Reporting  Requirements. There are only three;

Each written or oral real property appraisal must: 

a) clearly and accurately set forth the appraisal in a manner that will not be  misleading; 

b) contain sufficient information to enable the intended user(s) of the appraisal to  understand the report properly; and 

c) clearly and accurately disclose all assumptions, extraordinary assumptions,  hypothetical conditions and limiting conditions used in the assignment. 

The rest of Standard 2 addresses, in some detail, what information must be included in an  Appraisal Report. This includes identifying the client and any intended users, identifying the  subject property, identifying the intended use, the interest valued, and the type and definition  of value. It includes stating the date of value and the scope of work undertaken. The Appraisal  Report must include sufficient information to indicate that the appraiser complied with the  valuation standards included in Standard 1 of USPAP. Finally, the report must contain a value  conclusion and a signed Certification. 

Generally, an appraisal report format falls into one of four categories. These are; the oral report,  the form report, the letter report, and a narrative report. Each report format has its place, but  they are not automatically interchangeable. Often, it is the intended use of the appraisal that  determines which format is most appropriate.  

An oral report can seem illusive. In its purest form, there is no tangible evidence of a report.  However, per USPAP, the same standards apply to an oral report as to any written report. That  certainly includes the above cited general requirements along with the other items required in  all Appraisal Reports. Perhaps the most common form of oral report is expert testimony in a  deposition, hearing, or trial. Even when a formal written report is not required, many appraisers  feel a letter or memo report format (Restricted Appraisal Report) is good to have as an adjunct  to the oral testimony.  

While there are various iterations, a form report generally refers to a report designed for use by  lenders in considering residential value in mortgage underwriting situations. It is this report  that the typical consumer is most likely to have encountered. However, the reports are designed  for and by lenders (Fannie Mae and Freddie Mac). They are standardized and uniform so that  reviewers, underwriters, and loan committees can readily find information that is needed for  consideration of real estate as security for a mortgage. Much of the report consists of boxes to  be checked and blanks to fill in. The language in the report is often cryptic and not readily  understandable to the casual reader. Many professional appraisers feel that these reports are  inappropriate for any use other than for a lender. They risk being in violation Standard Rule  2-1b. When the user is anyone other than a lender, the reports likely do not “contain sufficient  information to enable the intended user(s) of the appraisal to understand the report properly”.  

A letter report is probably the least common of the reporting options. It is often used in  situations where the intended user is knowledgeable about the property and the valuation 

process. The letter report is succinct and includes the basics with little that is superfluous to  the value of the property. An offshoot of the letter report is the memo report which is really  only a variation in style. The letter report is frequently labelled a Restricted Appraisal Report  which puts the reader on notice that it may not be readily understandable to anyone other than 

the intended user.  

Finally, there is the narrative report. As indicated above, this report is the direct descendant of  the earlier discussed “MAI Appraisal”. It can vary in length and detail, but it is the most  inclusive of the reporting options. Generally, the report format leads the reader from laying  out the underlying premises of the valuation, a description of the property with photos, a  consideration of highest and best use, and the valuation section that can include two or three of the “approaches” to value. Ideally it is a stand-alone document that can be read and understood  by typical consumers. With modern technology, narrative reports are not much more difficult  to produce than the form or letter options.  

In making the distinction between the valuation and the report, it is important to point out that  the scope of work for the valuation may be exactly the same regardless of the reporting option.  All reports should include a Scope of Work. The Scope of Work is included to inform the  reader as to what was, and what was not, done in the valuation. A shortened reporting format  does not mean the valuation was limited in any way. And, a limited scope valuation can be  reported in a lengthy narrative document. As stated above, the intended use of the appraisal is  often the determining factor in deciding which reporting format is appropriate.

Mr. Arnold is a principal at Hammock, Arnold, Smith & Company. They are a general practice  appraisal firm providing valuation and evaluation services to a variety of clients including  corporations, government agencies, the legal and accounting communities, financial  institutions, private individuals, and others.

Value, Price, and Cost: They are not the same thing

To a layperson, the terms value, price, and cost may seem to mean pretty much the same thing. However, to the professional appraiser, the terms each have a specific meaning. And the meanings are most certainly not the same thing.

Market Value is the focus of many appraisals. Market Value is an opinion. In simplest terms, it is most probable sale price in an “arm’s length” transaction. However, simple terms rarely suffice. The definition is usually modified with certain assumed conditions. In a definition often used by professional appraisers in the United States (from the Comptroller of the Currency), the conditions assumed are very specific. Market Value is defined as the most probable sale price when the buyer and seller are typically motivated and reasonably well informed. Further, it is reflective of a typical marketing period and payment in terms of U.S. dollars with no influence from sales concessions or special financing.

There are many variations of the definition. The sources include the California Civil Code, the California State Board of Equalization, U.S. Treasury, Civil Jury Instructions, Internal Revenue Service, International Valuation Standards, and many more. As an example, the market value definition for reporting federal estate taxes is not exactly the same as the definition for local property tax assessment. In most cases, the definitions are intended to mean the same thing (or very nearly the same thing) as the definition referenced above. However, there are exceptions. In eminent domain actions (State of California rules), damage assessment in litigation, and a few other instances, the market value definition specifies “highest” price rather than “most probable” price. The intent is clear; the benefit of the doubt is intentionally extended to the property owner.

Finally, no discussion of Market Value would be complete without reference to the term “Fair Market Value”. The term is often encountered when dealing with legal matters. The various definitions of Fair Market Value do not suggest that the meaning is any different from simply Market Value. In fact, the U.S Supreme Court, in an eminent domain case (United Stated States vs. Miller), observed, “the term ‘fair’ hardly adds anything to the phrase ‘market value.’“ Most appraisers do not use the term. It has been observed that the term “Fair Market Value” suggests that there could be an “Unfair Market Value.”

Sale Price is a fact. Sale price is the agreed upon consideration upon which a buyer and seller agree to a transfer of property. Sale prices can be reflective of value but are not necessarily so. In a situation where a seller is under pressure, the price accepted might be lower than market value. Similarly, a buyer under pressure or motivated by other considerations (e.g. owning adjacent property) might pay more than market value. A property that has to be sold quickly might sell at below market value. There are any number of things that could impact sale price.

When undertaking Data Comparison Approach valuation analyses, professional appraisers survey markets for evidence of sales of “comparable” properties. The sale price for each property needs to be analyzed to determine if it was impacted by any influence that could cause the price to be something other than market value. It is as a group that the analyzed sales data help point to an indication of market value for the subject property.

Construction Cost is the cost to build a structure or other improvement. If Construction Cost refers to numbers compiled prior to actual construction, it is an estimate. It is often prepared by a contractor or cost estimator. If Construction Cost refers to numbers put together reflecting actual costs of construction which has been completed, it is factual. In either case, it is a unique number to a specific project and prepared by a particular person. Anyone familiar with construction knows that costs can vary depending on the project and the preparer.

Replacement Cost is most often used by appraisers when performing a Cost Approach valuation analysis. As such, it is an opinion. It is an estimate of costs to construct a structure comparable to the subject using current standards, materials, and practices. The Cost Approach valuation analysis is based on the premise that the cost to acquire a comparable site and construct similar improvements should be suggestive of value. However, an often quoted mantra amongst appraisers is “cost does not equal value.” Generally, people expect that the value will exceed the estimated cost. If it were not so, things would rarely get built.

Reproduction Cost is the estimated cost to build an exact replica of the subject. It is used by appraisers when a structure has unique components that are not reflective of current materials or practices but are considered desirable and therefore could add value. It also might be appropriate when a cost evaluation is being prepared for insurance purposes.

Professional appraisers regularly deal with value, price, and cost. The concepts overlap and influence one-another but the terms are not synonymous.

Mr. Arnold is a principal at Hammock, Arnold, Smith & Company. They are a general practice appraisal firm providing valuation and evaluation services to a variety of clients including corporations, government agencies, the legal community, financial institutions, private individuals, and others.