Highest & Best Use Analysis In The Appraisal Process

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There are many valuation products out there. CMA’s, BPO’s and AVM’s to name a few. What you will likely not see in those kinds of valuations, is the specific zoning class for the property being valued. Why?

With these types of valuations, a highest & best use (HBU) analysis is generally not made. However, if you hire an appraiser to value your home, we will perform this analysis. What is a highest & best use analysis? Why is it important in the development of an opinion of value? How is zoning involved?

Let’s talk about what a highest and best use analysis is. Market forces are the cause of different uses of real estate. Those forces affect market value. Therefore, it is important, in the development of a supportable opinion of value, to determine what the property’s highest and best use is. In other words, what is the most productive use (economically speaking) of the property? How do we make this determination?

There are four questions that an appraiser must answer about the property being appraised. This is how we “test” the highest and best use of a property. Here they are:

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1. Is the property’s current use legally permissible?

2. Is it physically possible to use the property for a specific use?

3. Is it financially feasible to use the property for a specific use?

4. Is the current use most profitable?

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In municipalities in which there are zoning regulations, the first question cannot be answered without determining the zoning class for the subject property. We must determine what use or uses are legally permissible. This is determined by finding out what the zoning class of the subject property is, and then analyzing the zoning ordinances for that specific class, to see what the subject property can legally be used for.

There are three other questions that are part of this HBU test. I will discuss these other questions in a future blog. In this article, I am just focusing on zoning.

Many counties and municipalities have also utilize “usage” codes. This is a code that the county or municipality use to identify what a particular property is being used for. This is not a zoning class. Usage codes are not used in a HBU analysis. Why?

A property may be used as a residential property. However, it may be zoned for another use. It may be zoned for retail, commercial or industrial use. The highest and best use of the subject may be something other than its current use. That’s why, after determining the zoning class of the property, three other questions need to be answered. There are times when the highest and best use of a property may be residential, even though the zoning may support a different use. There are many factors that must be analyzed in making this determination.

Why is a HBU analysis important in the development of a supportable opinion of value?

WHY ZONING AND THE HIGHEST AND BEST USE ARE IMPORTANT

There are times when a home may be used as a residential dwelling.  However, it may be zoned for another use. In some cases, a property may demand a higher potential income, and therefore a potentially higher market value, than it would as a residential property.

At times, municipalities change zoning in order to change the economic development of an area, based upon changing demographics and other market forces. I have seen situations in which residential properties have had their zoning changed to a commercial zoning. In one case, the city stated that if the property was sold or destroyed, it would not be able to be used or rebuilt as a residential property. As you can imagine, this situation had a direct impact on the marketability and market value of that property.

There are times when a home can be used or re-built as a residential property, despite having a commercial zoning. This would be considered a legal non-conforming use. In this situation, a lender will often require a “re-build” letter from the municipality stating that if the property was destroyed, it can be re-built and re-utilized as a residential property.

When it comes to market value, when a residential property is zoned for commercial use, often that property is influenced by commercial properties that are located within close proximity. A residential property located next to commercial properties, like an industrial warehouse or airport, will probably have an inferior market value, in comparison to homes that are surrounded by other residential properties. Of course, sometimes being located in close proximity to commercial properties is desirable to the market. For instance, if the property is in an area in which it is close to desired shopping and restaurants. Every situation is different.

In my area, one zoning situation I see on a regular basis, are homes in which the lot size of the property is smaller than the minimum lot size the current zoning allows for. If the municipality states that this is permitted, then the use would be legal non-confirming.

There are a lot of things to consider when it comes to zoning. Getting the analysis wrong can lead to an inaccurate opinion of value. As I mentioned eaerlier, a highest and best use analysis cannot be made with simply a usage code.

Furthermore, this particular analysis is not generally made by real estate professionals that provide CMA’s or BPO’s. So, their analysis may miss some very important issues that may affect value.

COMPARABLE SALES USED IN THE APPRAISAL

For a home to be truly comparable to the property being appraised, it needs to have the same highest and best use. So, an appraiser needs to be familiar with what the zoning of the subject and the comparable sales.

If I am appraising a home with a legal non-conforming use, I always provide at least one comparable sale that also has a legal non-conforming use. This helps to demonstrate what, if any, market value and marketability issues there may be with this type of situation.

BENEFITS OF HAVING ZONING REQUIREMENTS

Zoning requirements are used to help guide economic development. They are also used to provide conformity to a neighborhood. Without zoning ordinances, all sorts of strange types of structures may be built. Of course, sometimes that is the case even with zoning.

Here is a fun little video of some odd properties. (Full disclosure. I have no idea if these properties were built in areas with zoning ordinances)

 

There is an interesting article written by Benjamin Schneider, entitled “How to Understand Municipal Zoning Codes”. (Click here to read) It is a good read. It provides some great information regarding the history of zoning and how it works.

As I have mentioned several times in this article, CMA’s, BPO’s and AVM’s are not going to perform this important analysis. That is why it is important to hire a real estate appraiser when you really need a supportable opinion of value. Appraisers provide a far deeper analysis than many other types of valuation products. A deeper analysis can lead to a more supportable opinion of value. It may save you a lot of grief down the road.

By the way, there is a lot more to a highest and best use analysis than this article covered. I just touched on the basics.  As Forest Gump says, “That’s all I have to say about that.”

Have a great day! Thanks, as always, for reading my article. I hope it gave you some things to think about.

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Here are some links to other articles and videos I enjoyed recently! I hope you will also…

Digging In Can Be The Best Housing Defense – Housing Notes by Jonathan Miller

Common Questions Agents Ask The Appraiser – Birmingham Appraisal Blog

Can you use brand new sales from the builder as comps? – Sacramento Appraisal Blog

Newz;Refi Mania – Paper vs. Google Maps – GLA Split/Bi-Level homes- APPRAISAL TODAY

Is there a New Valuation Body of Knowledge? – George Dell’s Analogue