You have probably heard the term 'highest and best use' several times as you are making real estate purchase and development decisions.
The term actually has at least three definitions that you should be aware of, with one of them as the preferred definition for making the appropriate real estate decisions.
The first definition of highest and best use is that it is the use for a piece of land, or property in general, that maximizes your net present value (NPV). In other words, the highest and best use of a piece of land right in the middle of downtown is probably a high rise office tower since that option provides the greatest NPV. A single family dwelling on prime down-town real estate would not maximize your return from the property.
This definition also accounts for total NPV for the project. If there is an existing building on the project that generates cash flow or would cost money to demolish, these costs should be figured into your NPV calculation.
Highest and best use is the use which maximizes the net operating income (NOI) on the land. Net operating income is the net return to the owner before income taxes. In other words, you take your gross revenue, subtract out expenses, and figure out what is left over.
This definition differs from number 1. In number 1 the highest and best use is based on a positive NPV that takes into account your returns discounted at your opportunity cost of capital. This definition simply looks for the project type that generates the greatest amount of net operating income.
Highest and best use is the use that maximizes the NPV from owning the land if nothing were there already. In other words, you would look at a piece of ground and pretend it was vacant land. If that were the case, what would you build to give you the highest return? Whatever it is, that is the highest and best use.
Which Definition Is Best?
For all practical purposes, definition #1 is what the best developers in the world use. Definition #2 clearly has limitations. There are many projects that will produce immense amounts of cash flow and produce tons of net operating income. However, these same projects may have tons of risk associated with them and may not provide the returns on cost that you are looking for.
Definition #3 also ignores significant costs and opportunity costs of the property in question. If you have an old dilapidated building on a piece of property, you have to take into account the fact that the building is still capable of producing some income. That should be considered into your calculation.
Be careful to denote the difference between sunk costs and opportunity costs while making your calculation. The cost of demolishing a building is an actual cost to your current project. The net operating income (NOI) you will lose by demolishing the building is also an actual cost to your project. The replacement value of the old building, however, is irrelevant.
In conclusion, be sure to use definition #1 when making your real estate decisions. The highest and best use is the uses which maximizes the NPV of your project, subject to existing conditions, constraints, and opportunity costs.