How to avoid the “highest and best use” trap
Use your imagination.
I hear it all the time from my real estate clients: I want my project to have “the highest and best use.”
In case you’ve never heard it before, the expression “highest and best use” means using a piece of property in a way that maximizes its economic value. It means making the most of your opportunity, depending on where you are.
If your property was sitting on top of the Mother Lode, your highest and best use might be gold mining. If your property was on Times Square, it might be a theater or a hotel.
It’s a completely subjective and non-legal concept. It’s basically meaningless, kind of like the phrase “time is of the essence” that you sometimes hear a neophyte lawyer bandy about. You would never catch an experienced attorney worth their billing rate using the phrase “time is of the essence.” But a novice thinks it makes them sound knowledgeable.
Same thing with “highest and best use.” Novice real estate brokers and developers who don’t have a background in law or economics or land use planning think it sounds official and objective.
So when one asks me how they can achieve the “highest and best use” on their project, I ask them the same question:
“Do you really mean that, or do you really mean that you want the most profitable project?”
Because there’s a big difference.
One is fiction. One is reality.
“Highest and best use” is imaginary. Profits are what’s real.
You only have to take a quick look around to realize that’s true. Take the city of Detroit. At one point in its history — not all that long ago, in the grand scheme of things — the “highest and best use” for much of the city was factory floors and high-density housing. Now it’s open space and community gardens.
And it’s not just the Rust Belt. Even some of the most vital and dynamic cities in the United States have barren bald spots in some of their most prime locations because the market thought that their “highest and best use” was a Kmart or a Sears. Perhaps these locations were profitable for a decade or two — or three at the most. But these projects failed the test for delivering long-term value for their investors and their communities.
As an investor, how do you avoid making the same mistake on your next project?
It’s simple really. You have to use your imagination. You have to imagine many possible futures. And you have to take four important steps.
First, you have to figure out what you’re entitled to right now, by right.
Your project site — like every piece of property everywhere in the United States — has an existing matrix of entitlements that spell out exactly what you can do with it. These entitlements may include zoning, or a regional general plan or specific plan.
They will tell you whether you can build a hotel, or a slaughterhouse, or a lifestyle shopping center. Right now, by right. You could dream about putting a zipline park or a roller coaster in the middle of the city. But it’s not going to happen if your zoning limits you to townhouse apartments.
You have to focus on these as-is entitlements because they’re your project’s real source of value.
Everything else is in the land of daydreams, rainbows and unicorns.
Second, you have to keep up with change.
Warren Buffet told a great story about two farmers living side-by-side on identical farms. While one does his plowing and planting, the other constantly shouts over the fence to his neighbor what price he would be willing to buy his farm for, or what price he would be willing to sell his own farm for. The price is always changing, depending on the weather or what kind of mood he’s in.
The same thing applies to your project.
The world is always changing around it, every day. The supply and demand for goods and services around it is always in flux. The city builds a convention center a block away, and suddenly it’s a great spot for a hotel. Or a big high-tech manufacturer moves into town, and suddenly apartments make a lot of sense because its employees need housing.
Third, you have to inform your entitlement strategy with market intelligence.
Real estate investors often overlook marketing, but that’s a big mistake. You need good data to make data-driven decisions, and you need to put in place systems and processes to both detect and measure changes in your market.
How much time do you think will pass between when you secure the property and when your finished project is occupied? In the most permissive locations, that’s probably at least two or three years, and possibly much longer than that in prime locations. And how much do you think the market for your project will change in that time? Lots.
You face that possibility by building flexibility into the fabric of your project. For instance, you map the residential space for condominiums even when you expect to rent it out as apartments. You configure retail, office and restaurant uses to be modular and interchangeable.
Too much specificity in your entitlement strategy is the kiss of death.
Fourth, you have to undertake purposeful community outreach.
Before you commit to the project, figure out what the community is going to think about it and say about it.
Don’t you think there’s a chance they’re going to have a different vision for the site than you do? After all, they live there. You don’t. They know what their community needs a lot better than you do.
Community-based market research sharpens your vision for your project. It helps you optimize your product mix, and it helps you detect community relations pitfalls before you step into them.
So even though there’s no such thing as highest and best use, there is such a thing as imagination.
It takes imagination to envision a project that’s flexible, resilient, integrated with its community, and profitable.
This article first appeared on the Varamark Research blog at https://www.varamark.com/post/how-to-avoid-the-highest-and-best-use-trap