Highest and Best Use: The Four Tests – Agents Advantage Real Estate Academy

Most listings are what they appear to be: a house, on a lot, that will remain in use as a house much as it has been. A minority are not. The small original house on a large lot in a neighborhood of new construction, the single-family house in a zone that now permits two units, the old house on a shoreline lot where buyers have been paying for the land and removing the buildings: each of these can be priced two ways, and the two ways produce different ranges. The concept that separates them is highest and best use, and the question on such a listing is which use the market is paying for.

What highest and best use means

Highest and best use is the reasonably probable use of a property that is legally permissible, physically possible, financially feasible and maximally productive, and that results in the highest value. It is identified twice: once for the site as though vacant, and once for the property as improved. When the two answers differ, and the site as vacant is worth more than the site with the existing house on it, the house contributes nothing and the property is priced as land.

For most houses the analysis is short. The existing use is legal, the house is standing, it is worth more with the house than without, and there is no other use a buyer would pay more for. The four tests matter for the listings where that is not so, and a broker who applies them recognizes those listings before the price is set rather than after the listing has sat on the market.

The four tests, in order

The tests are applied in sequence, because a use that fails one is not carried to the next.

Legally permissible. What does the zoning permit on this lot, and what do private restrictions of record permit? A single-family lot in a zone that now permits two-family or accessory dwelling use has a legally permissible use the neighborhood’s older sales may not reflect. A lot in a zone that no longer permits the existing use, a legally nonconforming house, has a use that is permissible only while it continues. Deed restrictions, easements, conservation restrictions and inland wetlands or coastal regulations are also legal limits. The test is answered from the zoning regulations and the land records, not from what neighbors have done.

Physically possible. What can the lot actually support? Size, shape, frontage, topography, soils, wetlands, flood zone and access all limit what can be built. A lot that is legally permitted to hold two units but is too small to meet the setbacks for a second structure, or cannot support a septic system for it, fails this test for that use.

Financially feasible. Of the uses that pass the first two tests, which produce a return that exceeds their cost? A conversion that is legal and possible but would cost more than the finished property would sell for is not feasible, and the market generally does not pay for the possibility. Feasibility is read from the market’s evidence: what converted or rebuilt properties of that kind actually sell for, set against what the work costs.

Maximally productive. Of the feasible uses, which produces the highest value? Where the sales show buyers paying more for the lot as a site for a new house than for the lot with the existing house, the maximally productive use is the new house, and the property is a teardown regardless of the condition of the building on it.

What the broker does

A formal highest and best use conclusion is not part of a CMA. The broker does not perform that analysis and does not describe the office’s conclusion as one. What the broker does is recognize the situation, and the recognition is a matter of reading evidence that is already in the listing file.

The signals are consistent. Recent sales in the neighborhood where the buyer demolished or gutted the house after closing. Sale prices for older houses that cluster near the prices of vacant lots, or that show no premium for condition. A zone change or a new accessory-dwelling regulation. A lot materially larger than its neighbors, or one with frontage or water access the house does not use. A house whose sale price, if priced by comparison with other houses, would fall below what builders have paid for lots on the same street.

When the signals are present, the broker’s decision is which market the listing is priced in. A house that is a teardown is priced with sales of teardowns and vacant lots in that market, not with sales of comparable houses. Two further facts bear on that price: the cost to remove the existing structure, and whether zoning limits what can be built in its place, such as a rule that a new house stay within the original footprint. Both are researched with the town’s building department and zoning office. A house with a feasible conversion may have sales of both kinds that bear on its price, and the pricing position states which sales support the range and why. What the broker does not do is price a house as what it could be without evidence that buyers in that market are paying for the possibility; the tests are a way of finding the use the market is paying for, not a way of inventing one.

Application

A CMA is prepared for a 1,150-square-foot ranch, built in 1955 and in fair condition, on a 0.9-acre lot in a neighborhood where the lots are a quarter-acre and the houses are 1,400 to 1,800 square feet. Its three comparables are ranches of similar size and condition on quarter-acre lots, closed between $318,000 and $342,000, and the recommended range is $320,000 to $345,000.

A closer reading of the file begins with the lot. The zoning regulations for the district set a minimum lot of 18,000 square feet with 100 feet of frontage; the lot has 39,000 square feet and 210 feet of frontage. A subdivision into two conforming lots is legally permissible on its face and, on the survey in the file, physically possible. The land records show two sales on the adjoining street in the past year in which builders paid $265,000 and $280,000 for quarter-acre lots and built houses that closed at $690,000 and $715,000. The three comparables describe the market for a small ranch on a small lot. The evidence in the file describes a different market, in which buyers are paying for lots.

The broker does not conclude that the property is a two-lot subdivision. The broker recognizes that the range may rest on the wrong use, and the analysis returns to the sales of lots and teardowns, to the town’s subdivision requirements, and to the cost and time of a subdivision approval, so that the range presented to the seller reflects what buyers in this market have actually paid for land like this. The pricing position then states which use the listing is priced for, and why that changes the range.

Summary

Highest and best use is the reasonably probable use that is legally permissible, physically possible, financially feasible and maximally productive, tested in that order. A formal determination of it is not part of a CMA. The broker’s work is recognition: reading the zoning, the lot and the recent sales for the signals that a listing is being paid for as land or as a conversion rather than as the house standing on it. When the signals are present, the listing is priced with the evidence of the use the market is paying for, and the pricing position states which sales support the range and why.