Investing in commercial real estate requires comprehensive analysis to ensure you make the right decision. When you're looking to maximize returns and add a successful investment to your portfolio, it's highly recommended that you perform a highest and best use analysis.
This analysis aims to identify the most profitable and financially feasible way that a real estate property can be used. Factors like zoning laws and market demand help determine how to maximize a commercial property's value. Let's explore the importance of HBU analysis when making a real estate investment.
What Is the Highest and Best Use Analysis in Commercial Real Estate?
The highest and best use analysis is often performed while estimating the value of commercial real estate. This technique allows stakeholders to learn which use of the property will bring the most value. While appraisers examine a property's current use during this analysis, they also need to evaluate alternative uses.
How HBU Analysis Works
During the HBU analysis, the possible use of the property needs to meet four different tests to qualify. The use must be legally permissible, physically possible, maximally productive, and financially feasible.
Legally Permissible
This test involves local building and zoning regulations, which place a limit on the use and size of a property. Most appraisers have an in-depth understanding of the zoning regulations in their area. This test can incorporate environmental regulations as well to make sure the building doesn't do considerable damage to the environment.
Developers can choose to request a zoning variance if a larger project has a lot of potential. A variance allows the land to be used in a manner that's currently restricted by zoning regulations. Zoning variances are rarely awarded by the municipal body. To be approved for a variance, you'll likely need to prove that your project will boost the local economy significantly.
Physically Possible
The shape, condition, and size of the property must accommodate the highest and best use. Let's say that a potential use for a property involves providing 15,000 square feet of office space. If the site only allows for 8,000 square feet of space, you'll need to find another potential use.
Financially Feasible
This part of the analysis is designed to identify the financial feasibility of a specific property use. An appraiser can examine this possibility by making pro forma financial statements. There are many steps to this process, which include the following:
- Estimating potential cap rates
- Calculating vacancy rates
- Performing a full market analysis
- Estimating construction and development costs
Appraisers can use this information to obtain an estimated internal rate of return (IRR). A discounted cash flow analysis can also help determine if the net present value of the property is higher than the necessary return.
Maximally Productive
The maximally productive factor can only be looked at after a property's potential uses have been evaluated based on legal, financially feasible, and physically possible factors. The appraiser will then rank the potential uses based on the risk-adjusted returns. Don't be too quick to select the use that comes with the highest estimated returns. This strategy could be too risky for your investment portfolio.
Advantages of Performing HBU Analysis
Identifying the highest and best use for a property allows you to make a precise property valuation. Below are the main reasons why you should perform this analysis before you invest in a commercial property.
Maximizing Property Value
The HBU analysis can significantly enhance the value of your commercial property by identifying its most profitable and efficient use. For example, the analysis could show you that the best and most valuable use for your commercial building is retail.
Competitive Market Insights
This analysis considers zoning laws, demographic data, and current market trends, which means that it's based on a lot of useful information. You can use these competitive market insights to make more informed investment decisions that add value to your portfolio.
Strategic Development
By identifying the highest and best use of your commercial property, you can create a strategic development plan that considers all potential factors, ensuring your property investments align with market demand and yield optimal returns. Without this analysis, you could end up creating office space in an area that's transitioned to remote work.
Risk Mitigation
HBU analysis can help you mitigate investment risks by providing a thorough understanding of potential uses and their financial implications. Before you perform this analysis, consider how much risk you're willing to take on. The best use for commercial real estate could be one that's less risky but still provides high value.
Enhanced Decision-Making
Leveraging HBU analysis empowers real estate investors to make data-driven decisions that maximize returns and optimize portfolio performance. Our appraisers can give you accurate valuations that display the property's true potential.
Consider using ACRES' services for expert guidance on HBU analysis and commercial real estate decisions.
