Highest and Best Use in Real Estate: How Investors Maximize Property Value
What Is Highest and Best Use?
Highest and best use is the most valuable legal use of a property that's also physically possible and financially makes sense.
In plain terms, it's figuring out what would make the most money on a piece of land or building, while following the rules and working with what's actually doable on the site.
This concept shows up in every smart investment decision. Whether you're buying vacant land, looking at a worn down retail property, or trying to flip an aging office, your goal is to find the use that brings the most value, not just today, but over time.
Why the Concept Has Evolved
Back in the day, investors mostly relied on existing use. But markets change fast now. Zoning shifts, remote work, and new construction costs have pushed the industry to think bigger. That's where highest and best use comes in.
Say you've got a single story office building sitting half empty in a growing residential area. Ten years ago, you'd try to lease it again. Now? You might get more value converting it into townhomes or medical space. Times change, your strategy should too.
Vacant Land vs. Improved Property
If you're working with vacant land, it's about figuring out what to build. You'll look at things like zoning, access to utilities, slope, and local demand. Think: "What's the best use of this dirt?"
| Evaluation Criteria | Vacant Land | Improved Property |
|---|---|---|
| Zoning & Entitlements | Focus on what can be built and whether rezoning is possible | Evaluate current use and potential for variance or redevelopment |
| Physical Condition | Consider topography, soil, and build readiness | Assess building condition, code compliance, and retrofit needs |
| Utility Access | May require new utility connections or off-site improvements | Utilities typically already in place but may require upgrades |
| Development Costs | Higher upfront costs for ground-up construction | Renovation costs may be lower but carry unknowns |
| Timeline | Longer due to entitlement, design, and construction phases | Potentially faster if structure is usable or requires light repositioning |
But if the property already has a building, what we call an improved property, it's a little different. Now you're asking: "Do I keep it as is, fix it up, or scrape it and start fresh?"
Example: A 10,000 square foot strip mall built in the 1980s. Rents are low. The tenants are struggling. But the land is zoned for mixed-use. You run the numbers and realize you could build apartments and make a stronger return. In that case, the current use isn't the best use. Redevelopment is.
If you're analyzing land for development, these land parcels for sale can help you explore what's available.
Land For Sale
Why It Matters to Investors
Most people price a property based on what it is today. That's fine, but it's short sighted. Smart investors look at what it could be.
That's how you find deals. If the seller is valuing a tired office based on its current income, and you've figured out that the zoning allows for multifamily, you're ahead. That's the gap where profit lives.
This is also why understanding different types of commercial real estate is key. Some properties are better suited for repositioning than others. The more you know, the more you can spot hidden potential.
When in doubt, bring in a qualified appraiser. A good commercial appraisal based on highest and best use doesn't just tell you what something's worth, it tells you what's possible.
How Do You Determine Highest and Best Use?
Use the FourTest Framework
There's a proven way to figure out a property's highest and best use. Appraisers and investors use a four part test:
- Physical possibility
- Legal permissibility
- Financial feasibility
- Maximum productivity
You run through each test in order, filtering out what doesn't make sense until you land on the use that delivers the most value.
Test 1: Physical Possibility
This one's about what's actually doable on the site. You look at size, shape, topography, soil conditions, access to roads, and utility connections. If the land can't physically support a use, it's off the table, simple as that.
For example, you might want to build a five story multifamily project, but if the parcel is too narrow or has poor load-bearing soil, it's a non-starter. Always begin with what the land can physically handle before thinking about the economics.
Test 2: Legal Permissibility
Next comes the legal filter. This includes land zoning, building codes, easements, height restrictions, and even deed covenants.
Let's say your site is zoned commercial, but you think it's perfect for multifamily. You'd need to research whether a variance or zoning change is realistic. Sometimes it is, especially if other nearby parcels have made the switch.
Also look at long term planning documents and overlays. Just because a use isn't legal today doesn't mean it won't be permitted tomorrow. This is where a good understanding of land entitlements and the local planning climate can give you an edge.
Test 3: Financial Feasibility
Now you're asking: "If this use is physically possible and legally allowed, does it make financial sense?"
Here's where you run numbers. You model rents, expenses, cap rates, renovation or construction costs, and factor in risk. If a project doesn't hit positive net present value (NPV), it's not feasible. Period.
Test 4: Maximum Productivity
This final step compares the remaining uses. You're looking for the option that delivers the highest return relative to risk.
Just because one use shows a higher projected profit doesn't mean it's automatically the winner. You have to weigh risk, absorption timelines, capital needs, and exit strategy. One use might be flashier, but another could be more stable, and that often makes it more valuable.
This is where experience matters. Knowing how to interpret risk adjusted returns, and not just chase the biggest number, helps you pick the best long term play.
How to Evaluate Financial Feasibility and Risk
Once you've filtered for physical and legal possibilities, it's time to run the numbers. Financial feasibility answers the question: "Will this use actually make money?"
You'll need to model cash flows, estimate costs, and calculate potential returns. If a use doesn't pass this test, it doesn't move forward, no matter how appealing it looks on paper.
Use NPV, IRR, and Cap Rate to Measure Value
When you're narrowing down a property's potential uses, three financial metrics help guide the decision:
- Net present value (NPV)
- Internal rate of return (IRR)
- Cap rate
NPV tells you whether the investment's future cash flows, adjusted for time and risk, outweigh your upfront costs. IRR shows your projected annualized return, which you can compare to your required hurdle rate. Cap rate helps estimate value based on expected income, divide net operating income by the market cap rate to get a rough valuation.
Here's a side by side comparison of three hypothetical use scenarios to show how these metrics work together when determining the most viable option:
| Use Type | Net Present Value (NPV) | Internal Rate of Return (IRR) | Cap Rate | Risk Level |
|---|---|---|---|---|
| Retail Redevelopment | $1.4M | 12.5% | 7.8% | Moderate |
| Multifamily Conversion | $1.49M | 15.2% | 6.9% | High |
| Office Space Reuse | $1.25M | 10.8% | 8.3% | Low |
Don't Ignore Risk Adjusted Returns
A high return doesn't always mean a good deal. You also need to weigh the risk. A use that looks great on a spreadsheet might carry regulatory uncertainty, long vacancy periods, or high capital exposure.
Risk adjusted returns help you level the playing field. For example, a ground up development might offer a 20% IRR, while a rehab project only offers 14%, but if the rehab has less execution risk, faster lease-up, and a stronger location, it might actually be the better choice.
This is where tools like cash on cash return also help. It's a simple way to measure annual income against invested equity, especially useful for comparing short term or value add strategies.
Run Sensitivity and Scenario Analysis
Good investors don't just model one outcome. They test how a deal holds up under pressure. What happens if rents don't grow? What if construction takes longer? What if vacancy is higher than expected?
Sensitivity analysis lets you adjust key variables, rent, expenses, cap rate, to see how changes affect the outcome. Scenario planning goes even further by combining several shifts to model best case, base case, and worst case outcomes.
This step separates speculation from strategy. If a use still works under stress, you're on the right track. If it breaks with minor changes, it's not your best use.
How to Transition a Property to Its Highest and Best Use
Once you've identified the highest and best use, the real work begins. Getting from current use to optimal use without blowing your budget or your timeline.
Create a Phased Transition Plan
Start with a clear roadmap. Break your repositioning into phases and assign target dates, critical path milestones, and buffer time for delays. Typical phases include:
- Permitting
- Design
- Demolition (if needed)
- Construction
- Lease-up
- Stabilization
If your property has existing tenants, plan around lease expirations or negotiate early exits. In some cases, you can keep part of the property income producing while other sections are under construction. That helps offset holding costs and makes lenders more comfortable.
Want to see what properties near you might be primed for a higher and better use? Browse listings currently available.
Commercial Real Estate For Sale
Budget for Disruption
Don't underestimate downtime. Even with perfect planning, transitions create income gaps. Build a realistic proforma that includes vacancy periods, TI allowances, and leasing commissions. You'll also want to factor in higher operating costs during the conversion period.
Case by Case Tactics Matter
Some repositioning projects require more finesse. For example, turning an old office building into creative space may be quicker and cheaper than converting it into apartments. But each step, HVAC upgrades, fire code changes, plumbing reroutes, still takes time.
Track Performance After the Switch
Don't stop tracking once the renovation is done. Compare actual returns to your projections. If you're behind, figure out why. If you're ahead, use that data to refine your next deal.
The most successful investors treat building repositioning like a system. Every project teaches you something that improves the next one.
Frequently Asked Questions
What specific technology tools can help me conduct a more accurate highest and best use analysis?
Use GIS tools like ESRI to analyze land constraints, platforms like CoStar for comps and trends, and financial modeling tools like Argus or REFM for proformas. These give you sharper insights into zoning, value, and risk. Some investors also use digital simulations like Autodesk to test redevelopment ideas.
How can I navigate zoning changes to achieve a property's highest and best use when current regulations don't permit it?
Start by researching similar zoning changes nearby and speaking with local planners early. Build community support, use impact studies, and hire a land use attorney to guide the process. Expect 6 to 18 months for most rezonings, so factor that into your strategy.
