What Is the Definition of Highest and Best Use?
The term ‘highest and best use’ is widely recognised in real estate and property appraisals – particularly for development opportunities. It refers to the most profitable legal use of a property, determined by evaluating four key criteria:
- Legally Permissible: The use must comply with zoning laws, regulations, and other legal restrictions.
- Physically Possible: The property’s physical characteristics, such as size, shape, topography, and accessibility, must support the intended use.
- Financially Feasible: The proposed use should generate sufficient revenue to justify the investment, ensuring economic viability.
- Maximally Productive: Among the feasible uses, this criterion identifies the use that yields the highest value or return on investment.
From a financing perspective, incorporating the concept of Risk-Adjusted Return on Capital (RAROC) enhances this standard definition.
By applying RAROC, the highest and best use requires property developers to consider:
- How to best de-risk the project
- How to save time
- How to reduce the cash equity required to complete the project
In simple terms, answering the following questions helps maintain focus on the highest and best use when comparing development options for a site:
- What makes the most profit, with the least risk, in the shortest possible time, and with the lowest amount of cash equity?
Where to Start in Determining the Highest and Best Use
The best way to establish the highest and best use is by conducting a base case project feasibility analysis. This analysis should be supported by a cash flow model, funding tables, and a structured development program that outlines key project and risk milestones.
The Development Program
A development program integrates four key components:
- Project Feasibility – Establishes the profitability of the project.
- Contractual Milestones of Risk – Defines key project deadlines and risk factors.
- Cash Flow Forecasting – Determines how various development costs (design, approvals, construction) are funded, when, and by whom.
- Funding Tables – Identify required loans and cash equity during various phases of the project.
A well-structured development program is driven by the development strategy, which should be designed to mitigate key risks, including:
- Finance approval risk
- Development approval (DA) risk
- Market risk
- Project feasibility risk
- Land settlement risk
Key Financial Metrics to Measure Highest and Best Use
At a minimum, the development program should produce the following key financial metrics:
- Development Margin on Total Development Costs (TDC) – Measures profitability relative to costs.
- Internal Rate of Return (IRR) on Cash Equity – The most critical metric for developers scaling their portfolio.
- Total Project Profit – The absolute profit figure derived from the project feasibility.
To determine the highest and best use, these metrics should be compared against alternative development programs to assess their financial performance.
Why IRR on Cash Equity Is Critical
For most emerging property developers, the most limited resource is cash equity. Efficiently leveraging cash equity in a risk-averse manner is crucial for scaling up.
To maximise returns on cash equity, developers must determine:
- How much cash equity is required throughout the project lifecycle
- The timeline for equity deployment and repayment
- Strategies to minimise equity outlay while maximising returns
Final Thoughts
The highest and best use of a development site is determined by analysing project feasibility, cash flow forecasting, and risk management. By structuring a development program and incorporating a funding table, developers can optimise capital efficiency, mitigate risks, and ensure the best possible financial outcomes.
The ultimate goal is to achieve the highest return on cash equity while minimising exposure to risk, aligning with the core financier’s perspective of:
- Maximising profit
- Minimising risk
- Achieving results in the shortest time frame
By taking a strategic approach to financing and risk management, you can ensure your project stays on track and delivers the best possible returns.
This article first appeared in DFP.
