Highest and best use analysis in residential real estate appraisal remains a mystery to most appraisers. This is not a function of appraisers not being able to master the concept’s intricacies. Rather, the real estate appraisal education establishment does not require students to learn the components of highest and best use. Evidence of this is how much time basic appraisal education devotes to the topic.
As a result of this omission, many appraisers find themselves before state boards facing charges. This is not simply because they made an error in the appraisal or report. It is because they did not know what they were doing relative to highest and best use, thus made an error. They made an error because they had no cogent, intelligent instruction or leadership in it, thus did not know how or why they made an error.
There is no time to cover here this concept in the depth it deserves. Therefore, it merely covers the surface areas, and then only from a standpoint of USPAP’s requirements [see SR1-3(a) and (b) and SR1-4(a), (b), and (c)]. Since residential real estate appraisals must be USPAP-compliant, it makes sense to cover its requirements so the appraiser can determine if what s/he includes in an appraisal report complies.
This is SR1-3(a), the highest and best use Standards Rule, in its entirety, from the 2020-2021 USPAP text:
“When necessary for credible assignment results in developing a market value opinion, an appraiser must…identify and analyze the effect on use and value of: (i) existing land use regulations; (ii) reasonably probable modifications of such land use regulations; (iii) economic supply and demand; (iv) the physical adaptability of the real estate; and (v) market area trends…Comment: An appraiser must avoid making an unsupported assumption or premise about market area trends, effective age, and remaining life” (ibid; emphasis added).
This blog treats each of the above components individually, then ties them together at the end. Again, this is not meant to be an in-depth analysis (there just is not enough space). This is but a summary only of the concept and sub-concepts of highest and best use. First, we’ll cover the highest and best use boilerplate there is in most residential real estate appraisal software.
The Boilerplate – Fannie Mae’s 1004 Form
Under Site on the 1004 form is the question, “Is the highest and best use of the subject property as improved (or as proposed per plans and specifications) the present use?” The acceptable responses are only “Yes” and “No”, which the appraiser indicates by checking a box. If the answer is “No”, then the appraiser is supposed to “describe” why s/he checked that box. Unfortunately, the form does not tell the appraiser what it is s/he must describe. Even though the appraiser does not know what to describe, that description is a requirement of the Fannie Mae form. Note that on the form itself, this one reference is the only mention of the concept of highest and best use. This despite the requirement of USPAP’s SR2-2(a)(xii) that “…when an opinion of highest and best use was developed by the appraiser, state the opinion and summarize the support and rationale for that opinion [in the report][1]” (ibid; emphasis added). Thus, unless the appraiser adds supplementary analyses on highest and best use (typically in the addendum), the 1004 form itself puts the appraiser into the position of omitting the requirements of SR1-3(a) and (b). That omission calls into question both the appraiser’s grasp of appraisal ethics and the appraiser’s competency.
Identification of Existing Land Use Regulations and Reasonably Probable Modifications to Them
This is typically the zoning and land use plan as the local zoning jurisdiction has adopted them. That USPAP expects the appraiser to analyze both is evident in the use of the plural term “regulations”. Since the land use plan governs the zoning, USPAP expects the appraiser to look at the land use plan to determine if (a) the underlying zoning is compatible with it, and (b) if there is any potential for a change in either.
When it comes to change, remember that the appraiser looks at the property “right now”, and then is done with the assignment. Fannie Mae (and/or the investors to whom she sells her paper) look at it for 30-years, the term of the mortgage (OK. Mortgagors pay off their loans typically in less than 10-years). Therefore, part of the risk for which Fannie Mae, et al, must account is that of an adverse change in land use or land use regulations during the loan’s holding period. The appraiser picks up the phone, calls the zoning authorities, and then asks if there are any movements afoot to change the zoning (a legal road that is difficult, time consuming, and expensive to follow) or change the overarching land use plan (a legal road that is really difficult, really time consuming, and incredibly expensive to follow). Via picking up the phone, and asking these questions, the appraiser determines if there are any reasonably probable changes to zoning and/or land use.
Therefore, the appraiser identifies land use regulations as part of the highest and best use analysis. But even more importantly, the appraiser must first analyze the zoning and land use plan to be able to identify how they affect the subject’s market value and its marketability.
In other words, the appraiser must conclude, based on an analysis of market evidence, if, why, and how the zoning and land use plan affect the subject’s value and marketability. Then, s/he must explain in the report the processes of that analysis and reaching that conclusion.
Identification of Economic Supply and Demand Factors
Supply Factors
These two components of highest and best use may be the most occult of all of its components simply because most appraisers are not trained economists. Therefore, they are also not trained in the accurate and unbiased measurement of these two items. Unfortunately, while both USPAP and Fannie Mae require these analyses, both merely assume the appraiser is capable of such analyses.
Supply is merely how much there is of something. In the contexts of USPAP and Fannie Mae, supply of housing (or whatever it is you’re appraising) is the number of houses on the market, but that are directly competitive with, and comparable to, the subject. If you are appraising 3,500 square foot house on a one-acre lot, then the 1,800 square foot ranch-style on a quarter-acre site, while actively on the market, is not competitive with, not comparable to, your subject. Therefore, it is not part of the housing supply the appraiser would analyze.
That this is true has support from the Fannie Mae Selling Guide. This is from B4-1.3-03, Neighborhood Section of the Appraisal Report (08/07/2018), Trend of Neighborhood Property Values, Demand/Supply, and Marketing Time:
“When completing the One-Unit Housing Trends portion of the Neighborhood section of the appraisal report forms, the trends must be reflective of those properties deemed to be competitive to the property being appraised. If the neighborhood contains properties that are truly competitive (that is, market participants make no distinction between the properties), then all the properties within the neighborhood would be reflected in the One-Unit Housing Trends section. However, when a segmented or bifurcated market is present, the One-Unit Housing Trends portion must reflect those properties from the same segment of the market as the property being appraised. This ensures that the analysis being performed is based on competitive properties” (ibid; emphasis added).
Therefore, if the appraiser were to use MLS as a data source for analysis of the housing supply, the appraiser must also be aware of at least three (3) limitations of such a search (since these limitations can be an indication of selection bias): (a) any MLS system lists for sale only those properties (i) to be sold thru it, and (ii) only those listings its member brokers choose to submit thru it; therefore (b) the local MLS system cannot provide a complete cohort of comparable listings (i.e., supply) since it does not include FSBOs and builder sales; and (c) given that MLS systems exist for the benefit of its member brokers, not appraisers, the abilities of any MLS system to drill down sufficiently to provide the appraiser with an accurate list of properties comparable to the subject may not be present. Consequently, this lack of an ability to capture an accurate picture of the supply of competitive properties as of the date of the appraisal may compromise the quality and accuracy of an appraisal’s analyses.
In addition to the above, the concept of supply also contains a component of what the supply of competitive and comparable housing will be in the future (i.e., after the effective date of the appraisal). MLS data, which are entirely historical in nature, cannot aid the appraiser in predicting the future. To predict the future, the standard protocol is to use US Census data which does contain the Census’ projections, thus can help you peer into the future.
Unfortunately, the appraiser also must have the software and know-how to manipulate Census data to take this peek. However, if the appraiser does not know what to put in, then what comes out is open to question. There are providers who will happily provide the necessary census data. However, those providers do not provide their data and expertise for free. Such analyses can be so expensive as to make their purchase financially infeasible for the individual boots-on-the-ground appraiser.
Therefore, the appraiser is generally limited to historical MLS data, which are but one-half of the picture. Nevertheless, the appraiser has the responsibility to analyze supply, as well as to certify that any statements of fact the report bases on the data are true and correct. Note, too, USPAP’s SR1-4 requires the appraiser to “…collect, verity, and analyze all information necessary for credible assignment results”, not merely all information available (ibid; emphasis added).
Therefore, an analysis of the supply component of highest and best use must analyze all of the information necessary for credible assignment results, not merely the portion of it available on MLS. To limit one’s analyses solely to available MLS data, thus ignoring (a) data not available on MLS [e.g., FSBOs] and (b) future supply factors, is to engage in (at least) selection bias. USPAP’s SR2-3, the 2nd bullet point, specifically requires the appraiser to certify that “…the reported analyses opinions, and conclusions are limited only by the reported assumptions and limiting conditions and are my personal, impartial, and unbiased professional analyses…” (ibid; emphasis added). To certify there is no bias in an appraisal, yet to engage in selection bias, even unintentionally, is misrepresentation, a serious USPAP ethics violation.
Demand Factors
Demand (at least in a real estate context) has two components: (1) the desire to possess something; and (2) the ability to pay for it. Therefore, a major component of demand for real estate is the employment picture in a given area. This means there are active employers in the area (including both major corporations as well as small entrepreneurs); (2) these employers are financially sound and professionally managed; (3) the goods and services these employers provide are those consumers want and are willing to pay for; (4) the future tenure of these employers is reasonably long-term; and (5) the necessary socio-economic and socio-governmental infrastructures are in-place and functioning.
Since most people are not internet entrepreneurs, lawyers, doctors, and trust-fund legacies, they work a 9-to-5 job somewhere. In a community in which the median household income is $61,937 (the US median household income in 2018), all other things being equal, there will not be a lot of $1-million houses, since such folks do not have the monthly income to pay for them. So, as part of a neighborhood analysis, an appraiser studies income and employment patterns to determine the size of the pool of qualified buyers there is for the houses in the price range of that neighborhood. If that pool is too small, then there may be too much supply for that available pool. This presages a price decrease.
When the Fannie Mae 1004 form asks for the range of sales prices of houses in the subject’s neighborhood, it seeks more than that simple information. Since Fannie Mae’s correspondent lender has the potential mortgagor’s income data as part of the loan application package, it is easy for that lender to look at the predominant price of a home in the neighborhood (from the appraisal), compare that with the applicant’s income, and then use that income-to-price relationship as part of its loan underwriting criteria. Since one’s income depends (typically in large part) on one’s job, one’s job is part of the overall employment picture in an area. Since employment is a component of demand (which presages supply), and part of an appraiser’s highest and best use analysis is to measure demand for real estate in an area versus its supply, then an analysis of employment levels in a neighborhood is a component of the supply/demand sub-component of the highest and best use analysis. This is why appraisers study demand.
The Physical Adaptability of the Real Estate
To what use(s) can a parcel of real estate be put when it is no longer worthy of its original use(s)? There are numerous cities in the US with still-viable housing over 100-years old. Depending on the zoning (see above) and land use changes taking place in the neighborhood, it is possible that the only use to which a property can be put is that of residential housing. Yet, if land uses are changing, if there is no longer a demand for housing in a historically residential neighborhood, maybe it makes sense to raze the houses here and put the land to another use. Or, maybe, it is to keep the houses in the neighborhood, but repurpose them to another use. Thus, the physical adaptability of housing to be put to another use is not only a function of construction, architecture, maintenance, age & condition, and so forth, it is also a function of the public’s taste, thus supply and demand.
To determine if the market supports making a change in the physical real estate typically requires the appraiser to compare side-by-side (a) the cost-benefit ratios of making a change(s) versus (b) not making the change. In other words, if converting a house to one a lawyer or doctor would rent, (or buy) that is the “physical adaptability of the real estate”. If spending $150,000 to renovate the house-to-office use would give it $200,000 more value, then the highest and best use is to effect the renovations. If that level of renovations would not contribute to the property’s market value in excess of the costs of renovation, then the highest and best use would be not to make those renovations.
In the same vein, if the site, as if vacant, had a value of $100,000, but the site as improved (after taking into consideration the costs of razing the improvements) had a value of $100,000 or less, then the highest and best us would be to demolish the improvements and then either sell the vacant site or renovate it to its highest and best use. This is the side-by-side comparison that “physical adaptability of the real estate” requires when highest and best use as the present use is not clear and obvious. Yes, this is a great deal of work, and is likely above the expertise of an appraiser with a residential credential. But that is why USPAP has a Competency Rule – as a protection to the appraiser. It is also why appraisers must engage in the proper scope of due diligence before accepting an assignment, so they know how complex a credible completion of the assignment will be, as well as what to charge for a complex assignment.
Market Area Trends
This analysis answers two questions: “Where has the neighborhood been (and why)?” and “Where is it going (and why)?” Granted, the answer to the first question foundations on measurable historical fact. The answer to the second question calls for crystal-ball gazing. Nevertheless, that the neighborhood is transitioning from a majority of residential land uses to commercial land uses answers both questions. It also shows the point at which the neighborhood finds itself along the “neighborhood-life” curve: Is it (a) increasing, (b) stable, (c) declining, or (d) in revitalization? All other things being equal, a neighborhood undergoing the above transitions is in the revitalization stage (which implies a period of growth. This implication itself is one indication of neighborhood trends).
While such change is difficult to measure (since change typically comes about for a variety of reasons, not merely one), there are metrics. For example, over the last X-number of years, has the average number of building permits changed? In which direction? Why? Have sale prices changed? In which direction? Why? Has there been a recent zoning change? To what new classification from which former classification? Why? Is the local jurisdiction spending a lot of money to spruce-up a major roadway in the area? Why? What rewards does that jurisdiction expect to reap from the investment? The list goes on since there are too many reasons for change to list them all here.
Comment on the Comment to SR1-3(a)(v)
The Comment to SR1-3(a)(v) teaches that “…[the] appraiser must avoid making an unsupported assumption or premise about market area trends, effective age, and remaining life…” (ibid; emphasis added). This statement is a protection to the appraiser, really. It could have been written a more positive tone, true. Nevertheless, all it is teaching is that when an appraiser states in the report, “the subject has a remaining economic life of 45-years”, that statement must be both true and correct (see SR2-3, first bullet point). Since the appraiser certifies that it is both, there must be some support for that conclusion, otherwise the appraiser would not knowingly certify to it (or shouldn’t, anyway). In the report should be a summary of why the appraiser is sure that statement is true and correct. In the workfile should be, in detail, the support that the statement(s) is true and correct.
Consider the concept of Total Economic Life (TEL). Per SR1-4(b)(iii), the appraiser extracts depreciation from the market by estimating “…the difference between the cost new and the present worth of the improvements (depreciation)” (ibid; emphasis added). On p. 294 of Appraising Residential Properties (bibliographic citation omitted) is a tabular graphic showing how to extract depreciation from the market, as well as how to calculate TEL (so there is no reason to cover it here). This is the support SR1-3(a) contemplates when it comes to market trends since depreciation, which is a wearing-out of the improvements (a market trend) can speed-up or slow-down depending on how the market perceives the neighborhood’s reputation.
SR1-3(b)
Then SR1-3(b), in its entirety, declares the appraiser, after completing the above analyses, must “…develop an opinion of highest and best use of the real estate. Comment: An appraiser must analyze the relevant legal, physical, and economic factors to the extent necessary to support the appraiser’s highest and best use conclusion(s)” (ibid; emphasis added). This makes it clear that the appraiser cannot develop a credible highest and best use opinion until s/he as engaged in the five (5) analyses found in SR1-3(a) to the proper depth (which will vary from assignment to assignment).
OK. What Does All of This Mean?
An appraiser’s conclusion of highest and best use is an opinion, not a fact to be found. However, an opinion, to be credible, must have its foundation in facts, not merely feelings. Per SR2-3, the Certification Standard, when an appraiser makes a statement of fact, it must be true and correct. Indeed, the first bullet-point makes this clear; thus the appraiser certifies all statements of fact are true and correct. The appraiser does not hope they are true and correct. The appraiser does not feel they are true and correct. The appraiser does not even conclude they are true and correct. Rather, the appraiser certifies they are true and correct. That’s a powerful promise, as well as a weighty responsibility.
Therefore, the depth of an appraiser’s analysis of highest and best use does not limit itself to merely checking a box. In addition, the appraiser must tell the client and intended users why and how s/he reached that conclusion(s). True, as scope of work varies from assignment to assignment, so does the width, breadth, and depth of the highest and best use analysis. But according to both USPAP and Fannie Mae, there must be market-based support for that conclusion(s). Absent that support, the appraiser makes unsupported assumptions or premises about market area trends, effective age and/or remaining economic life. USPAP counsels us to avoid such a trap since therein lie sanctions.
If you have any questions about USPAP, your relationship with the state appraisal board, a review, or just want to make sure your appraisal reports are USPAP compliant, contact me, Tim Andersen, at tim@theappraisersadvocate.com. It will be my honor to consult with you. Thanks! Be safe and well!
[1] Whether the answer be yes or no, the appraiser must explain why and how s/he reached this conclusion.
From your lips ….
Thank you, Rick! Your thoughts are mine, too!
I know more about HBU after 20 minutes here than in my qualifying education and CE combined. This is very timely in Minneapolis where the city council has eliminated single family residential zoning. Two and three unit residential can be built (or chopped out of large houses) anywhere it is physically possible. Our appraisal regulator, the Minnesota Department of Commerce, sent a notice out to appraisers to pay close attention to HBU with this sweeping change in zoning. We need a webinar from you, my friend.
Scott: Thanks! Let’s write that seminar!