As Director of Property Management for my firm I always look at property, not only for what it is but also for what it could be. An outdated multi-story warehouse could be converted to a modern office building or revamped into a prosperous shopping center. Likewise, a building that appears efficient could have outdated features which (when converted) would make it far more attractive and cost-efficient. However, such transformations come only with effort: among other things, they require foresight; creativity; risk and financing.
As an expert in real estate investment strategy, the property management firm looks for alternatives that offer the highest value and still safeguard the investment. The choice ultimately rests on the answer to the question – what is the property’s ideal function, its highest and best use?
Highest and best use describes a superlative state for the property and not a comparative one (as in higher or better). The property management team tries to find the use for a property that meets the two explicit criteria, the use that is both the highest and the best. The two criteria go together, but to understand the whole concept, it helps to understand first how the two terms are different.
Highest Use.
The highest use is a term based on economic factors. It suggests that the success of an investment is purely in financial terms. Each investor has a different idea of what a property’s highest use should be – because each investor has a different expectation of the return from an investment.
Best Use. The best use transcends dollar considerations. It refers to sociopolitical factors that make one use more appropriate than another. This consideration is also subjective. The highest use of a real estate property may not be its best use and the best use is not necessarily its highest.
Imagine a large tract of beautiful wooded land divided by a babbling brook. The setting might seem best for scattered, prestigious, single-family homes. But a developer levels the trees, dams the brook, asphalts the property and fences it for a mobile home trailer park. The financial benefits from the trailer park would far exceed the one-time profits of scattered homes. The developer chose the highest use over the apparent best use.
There are four alternative options to consider when deciding whether to change a commercial property:
1) status quo;
2) rehabilitation;
3) restoration
4) modernization.
Status Quo. One way to achieve the highest and best use for the property is to maintain the status quo, keeping the property in its present condition, either developed or undeveloped. Not all properties need to be improved. A commercial property may be already functioning in its highest and best use. Land investments are a good example: some investors (notably corporations) choose to invest in vast parcels of unimproved real estate. Their decision does not necessarily reflect an objective highest and best use, but for each investor the concepts have different meanings. The owner could be holding the property for a number of reasons – taxes; appreciation; or to discourage competition. The property owner believes that the land is being used most appropriately. A charity or social organization might construct a meeting facility rather than a warehouse or shopping center on the site, which is a use other than the highest and best use. The nature and the origin of federally-subsidized housing dictate that it remain at the status quo, and that state does not necessarily reflect the highest or best use.
Rehabilitation. Second, an existing building can be rehabilitated. Rehabilitation refers to restoring a building to its original condition without changing the physical appearance of the property or repairing part of the building whenever maintenance has been deferred. The goal is to return the property to a well-maintained condition.
With cosmetic rehabilitation, attention is on form rather than substance, for example replacing a worn carpet or fixing cracked plaster. In these cases, the appearance of the building has changed slightly but not substantively.
If the property suffers from substantial deferred maintenance, comprehensive rehabilitation might be in order. Adding amenities, such as a security system, might be included in comprehensive rehabilitation. In the process of major rehabilitation features can be added that will help to achieve optimum rents. Making these types of changes will bring the property back to excellent condition without changing its use.
Restoration. Restoration should be differentiated from rehabilitation. Restoration is the process of returning the building to its original condition.
Modernization. The purpose of modernization is to replace out-of-date items with modern, cost-efficient materials, or items that increase operating efficiency. Modernization reduces the loss in value due to changing styles or functions, which is called functional obsolescence. Basically, modernization changes the product – the property – to meet the demands of the market.
In modernization program, thermal-pane glass might be substituted for regular glass; fluorescent or quartz lighting for incandescent; recessed fluorescent fixtures for acoustical ceilings; automatic elevators for manual ones. These are changes that either help the building function more efficiently or give it a more contemporary look. The ultimate goal of modernization is to extend the property’s economic life.