3.

3 HIGHEST AND BEST USE ANALYSIS

An understanding of market behavior is essential to the concept of HBU. Market forces create market value, so the interaction between market forces and
HBU is of crucial importance. Therefore, HBU is a market-driven concept. HBU analysis is typically provided by consultants. However, the nature of the
engagement sets limits on the extent of HBU analysis to be undertaken, and the characteristics of the property limit the number of alternative uses to be
considered.

Definition

Highest and best use may be defined as the reasonably probable and legal use of vacant land or an improved property, which is physically possible,
appropriately supported, financially feasible, and that results the highest value. The HBU of a specific parcel of land is not determined through
subjective analysis by the property owner, the developer, or the consultant, but by the competitive forces within the market where the property is located.
Therefore, HBU is an economic study of markets forces focused on the subject property. The benefit a real estate development produces for a community or
the amenity contribution by a project (like a public waiting shed along the city road) is not considered in the HBU analysis; HBU is driven by economic
considerations and market forces, not by public interest.

HBU Compared to Market Analysis and Feasibility Analysis

Market analysis: Purpose is to identify demand for alternative uses, though supply and demand analysis to forecast absorption rate and probable rents for
specific uses considered.

Feasibility analysis: Purpose is to determine respective values based on criterion variables (e.g., residual land value, rate of return, capitalized value of
overall property), through calculation of NOI/cash flows and selection of appropriate cap rate/discount rate to determine property value based on criterion
variables for specific uses considered.

HBU analysis: Purpose is to determine the use resulting in the maximum value through specifications in terms of use, timing, and market participants (e.g.,
user of the property, equity investor, and debt investor)

The three analyses are interrelated . However, feasibility analyses may involve data and considerations that are not directly related to HBU determinations.
Such analyses may be more detailed, have different focus, and/or require additional research. Generally, the feasibility of developing real estate under a
variety of uses is studied. The use that maximizes value represents the HBU.
HBU of Land as though Vacant vs. HBU of Property as Improved

The consultant should distinguish between HBU as though vacant and BHU as improved in the analysis. The consulting report should clearly identify,
explain, and justify the purpose and conclusion for each type of use.

HBU of Land as Though Vacant. There are three reasons to identify the HBU of land as though vacant in valuation: to estimate a separate land value; to
identify comparable sales of vacant land; and to identify external obsolescence.

The value of land is generally estimated as though vacant. When land is already vacant, the reasoning is obvious: value of land as it exists. When land is not
vacant, however, its value depends on how it can be utilized. Therefore, the HBU of land as though vacant must be considered in relation to its existing use
and all potential uses.

Land value can be based on potential, rather than actual, use. Example: consider a valuable commercial site in an excellent location that is currently
improved with a service station that is free of any negative surroundings. As an investor who wants to build a high-rase mixed-use building on the site may
pay a price for the property that includes no value, or usually governs the price that will be paid.

HBU of Property as Improved The HBU of property as improved is analyzed for two reasons:

1. To identify the property use that can be expected to reproduce the highest overall return for each peso of capital invested. This is important to informed
buyers who are economically motivated. Example: A property is currently being used as rental apartments. A buyer would want to know if this use will
continue to produce maximum benefits. If not, would the rate of return be increased by converting it to an apartment hotel? The value of the property
will differ under these two use assumptions.

2. To estimate the HBU of property as improved to help identify comparable properties. Both the HBU of land as vacant and as improved should be the
same or similar to each comparable property for the subject property. Example: it may be inappropriate to use a comparable property that has a HBU as
an office building in considering a property that has a HBU as hotel.
Example: HBU of Land as though Vacant

Single-Family Residence is an area zoned for detached, single-family home, some of which have already been built. The first HBU question is whether the
site should be develop or left vacant. Since the residential value of the site as though residentially improve is positive, the HBU of the site as vacant is to
develop it. The second HBU question is what type of residence to construct on the site. The builder has narrowed down the development alternatives to two
types of houses, both of which are compatible with other houses in the neighborhood. Use 1 call for the construction of large house with estimated market
value of P250,000 including the lot value. Use 2 calls for the construction of a more model house which would be worth approximately P200,000 with the
lot. Similarities in the area have been selling to builders for approximately P32,000 to P33,000. The estimated costs of constructing the two houses and
their respective value estimates can be used to identify the HBU of the land. Below are the calculations.

Use 1 Use 2
Market value P250,000 P200,000
Cost to construct new -187,000 -150,000
Builder’s fee -30,000 -24,000
Land Value P33,000 P26,000

The answer to the HBU question as to which improvement should be build is Use, the use that results in the higher residential land value. Similar sited can
be expected to sell for about P32,000 to P33,000. Thus, if P33,000 was paid for the lot and the smaller house was built, the builder would incur financial
loss.
Example: HBU of Property as Improved

Capital Expenditure Required. A warehouse property can be rented for P175,000 total net to the owners. However, the owners are considering converting
some of the warehouse space into office space and increasing the rent. The conversion would cost approximately P125,000 and would probably add to the
market value of the property, which is currently P600,000. An appraisal estimates that with the new office space, the annual rent could be increased to
P185,000, even though the amount of warehouse space would be reduced. The calculations used for the HBU analysis are shown below.

W/house use only W/house with office

NOI P175,000 P185,000
Overall cap rate 15% 15.5%
Capitalized NOI P1,167,000 P1,194,000
Conversion cost 0 - 350,000
Property value P1,176,000 P 844,000

Conclusion: The warehouse without offices is the HBU of the property as improved.

Criteria In HBU Analysis

The HBU of both land as though vacant and property as improved must meet four criteria. The HBU must be (1) legally permissible, (2) physically
possibl3, (3) financially feasible, and (maximally productive, often considered sequentially. The tests of legal permissibility and physical possibility must
be applied before the remaining test of financial feasibility and maximal productivity. Although the criteria are considered sequentially, it does not matter
whether legal permissibility or physical possibility is addressed first, provided both are considered prior to the test of financial feasibility. Many analyst
view the HBU analysis as a process of elimination. The test of legal permissibility is often applied first because it eliminates most alternative uses and does
not require a costly engineering study. It should be noted that the four criteria ate interactive and may be considered in concert. Matrix analysis can be used
to plot their interaction.
Example: HBU of Property as Improved

Capital Expenditure Required. A warehouse property can be rented for P175,000 total net to the owners. However, the owners are considering converting
some of the warehouse space into office space and increasing the rent. The conversion would cost approximately P125,000 and would probably add to the
market value of the property, which is currently P600,000. An appraisal estimates that with the new office space, the annual rent could be increased to
P185,000, even though the amount of warehouse space would be reduced. The calculations used for the HBU analysis are shown below.

W/house use only W/house with office

NOI P175,000 P185,000
Overall cap rate 15% 15.5%
Capitalized NOI P1,167,000 P1,194,000
Conversion cost 0 - 350,000
Property value P1,176,000 P 844,000

Conclusion: The warehouse without offices is the HBU of the property as improved.

Criteria In HBU Analysis

The HBU of both land as though vacant and property as improved must meet four criteria. The HBU must be (1) legally permissible, (2) physically
possibl3, (3) financially feasible, and (maximally productive, often considered sequentially. The tests of legal permissibility and physical possibility must
be applied before the remaining test of financial feasibility and maximal productivity. Although the criteria are considered sequentially, it does not matter
whether legal permissibility or physical possibility is addressed first, provided both are considered prior to the test of financial feasibility. Many analyst
view the HBU analysis as a process of elimination. The test of legal permissibility is often applied first because it eliminates most alternative uses and does
not require a costly engineering study. It should be noted that the four criteria ate interactive and may be considered in concert. Matrix analysis can be used
to plot their interaction.
Excess land (in appraisal): Land that is not needed to serve
or support a property’s existing use. The highest and best use
of the excess land may or may not be the same as the highest
and best use of the improved parcel. Excess land has the
potential to be sold separately and is valued separately. (See
example in Exhibit 1 below.)
       
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Highest and best use 2015