If the Highest and Best Use is Wrong, the Value can’t be Right

In Uncategorized by Patricia Staebler

In hindsight everything is so much easier to value, especially all these properties with overinflated values from the boom area, which ended too abruptly in 2006. After having prepared a lot of retrospective appraisals for subdivisions and multifamily complexes (mostly failed condo conversions), I had the opportunity to read a lot of the appraisals dating back to 2004 up to 2006, which today, in hindsight, were written in favor of the developer and the projects were doomed to fail and not even the review appraiser in the bank recognized what was missing in the big picture: demand.

My colleagues and I often discuss if we would have approached these appraisals differently than the appraisers did in 2006. It is so easy to sit there in the future and criticize what someone did in the past, with what we know today. Our group of appraisers specializes in difficult, complex assignments like failed subdivisions, failed condo conversions, etc. and we are comprised mostly of MAI and SRA designated appraisers. But after giving the question some thought, we came to the agreement that yes, we would have done it differently. And here is the reason why:

An essential part of every appraisal report is the Market Analysis section, which is needed to develop the highest and best use. The Highest and Best Use is the sacred cow of the appraiser’s world and an appraiser who does not understand the concept will not be able to deliver credible results.

Under my first supervisor, when I was a trainee with little to no knowledge of the market or appraising, I was told to use a template for the market analysis which never changed a whole lot, besides replacing the demographic data we downloaded from the chamber of commerce of the region we were working in. There was literally no connection between the market analysis and the development of the highest and best use. If the demographic data was positive or negative, it didn’t influence what the highest and best use of the property was. “It is, what it is”; a motto which only in rarest occasions was not followed.

A meaningful investigation of the highest and best use will always rest on a thorough supply and demand study, which is integrated in the market analysis. Let’s take for example a subdivision development; to estimate how much of the demand the product will be able to capture, we first have to investigate the planned subject property in a so-called property productivity analysis. Another important step is to estimate the demand (people moving to the area, buyer vs. tenant, disposable income, etc.) and subsequently the supply (how many other developers are in the process of building, permitting or announcing subdivisions). Where does the subject property fit into the picture? Is it the right product for the right price?

One assignment some years ago is a perfect example to explain how market analysis and highest and best use are intertwined:

We were hired to provide a market analysis for a 700 acres site, which was slated for single-family development with about 250 homes. The developer wanted to create a subdivision with homes from $300,000 to $500,000 and lot sizes ranging from ½ acre to 1 acre. However, he wanted to do his due diligence and therefore hired us to find out if his product was the right product in the right area, at the right time.

Besides several issues like water and sewer, concurrency, transportation mitigation, etc. we found, that there was an oversupply of homes in the price range targeted by the developer but a demand in the $120,000 to $170,000 price range, which geared towards low income housing. The highest and best use conclusion changed from development with about 250+ homes in the upper price ranges to 700+ homes with much smaller lots and a smaller living area. This was only possible, because we conducted an in-depth market analysis, which investigated the supply and demand.

Based on the highest and best use, the value conclusion for this property changed significantly, because the highest and best use changed.

Therefore the premise “If the highest and best use is wrong, the value can’t be right” is one of the most important considerations for every appraisal.

Now going back to the question, if the disaster of overbuilding subdivisions and “over-converting” multifamily complexes could have been avoided, the answer in my opinion is: not all, but most of it, especially late 2005 and 2006.

Road to nowhere – Failed Subdivision Development

Real Estate insiders knew in 2005, that we already had an oversupply of condominiums (purpose built and converted), but nevertheless there were still developers out there who converted Class B and even Class C multi-family complexes to condominium use. All this supported by appraisals, which did not investigate the market demand and supply correctly, subsequently lead to a wrong highest and best use and with that the value was not right. And the banks believed the fairytales and continued to lend and lend and lend.

Did the approach of appraisers change after the disaster of the last years? Florida lost over 10,000 appraiser licensees in the last five years and in my opinion this process alone cleaned up the appraiser ranks under the motto, “only the good ones survive in economically challenging times”. For the rest of us, left in the field, I hope that market analysis will become more and more an integral part of every appraisal.

Appraisers who are interested in learning more about market analysis should attend courses offered by the Appraisal Institute. Both, residential and commercial market analysis courses are available.

Believe me, market analysis works!

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