Highest and Best Use: Perspective on Prospective

Having just completed an update to the Continuing Professional Development (CPD 105) coursebook on Highest and Best Use for The University of British Columbia and an article for the Institute of Municipal Assessors’ Spring 2024 Insti-News journal, as well as speaking in multiple webinars and panels on the topic, highest and best use is clearly on the Johnstones’ minds. In this article, Charles and Haydn provide a brief overview of the theory of “Highest and Best Use” and why it is a critical step in any real property valuation.

Whether you know it or not, highest and best use is a key component of all our day-to-day lives, whether you drive by your old neighbourhood and say, “that used to be farm fields,” or contemplate how office buildings with vacancy rates of more than 60% can survive in the work-from-home era, or muse about how online shopping will impact the need for expansive shopping centre parking lots. The theory of highest and best use even surfaces in more unexpected places, such as Social Distortion’s “Story of My Life” lyrics, “And I went down my old neighborhood; The faces have all changed; There’s no one there left to talk to; And the pool hall I loved as a kid; Is now a 7-Eleven.” The passage of time not only influences but also complicates an opinion of highest and best use and, therefore, the value of real property.

A property’s highest and best use is the use of land that provides the maximum net return in the foreseeable future, with consideration for all legal, physical, financial, and market constraints. Or simply put, the reasonably probable use that results in the highest value.¹

Source: The Appraisal of Real Estate, 4th Canadian Edition, The University of British Columbia (UBC). Infographic from H&C Johnstone, Presentation for UBC, CPD 105.

Potential Future Use and Probability

Whereas most of us view change as what used to be versus what there is now, highest and best use explores what there is now versus what there may be. It is an educated prediction entrenched in the known facts of an imperfect market. Before you can jump into understanding the highest and best use, you must first understand what you are appraising and why. Seeking a solution when you don’t yet understand the problem is putting the cart before the horse. This can result in wasted time researching unnecessary information—or worse—not meeting your clients’ needs.

One of the key preliminary steps is to consider the property’s current and potential future uses and how these might influence its value. Any property may have value beyond its existing use, with development potential that only becomes obvious with further study.² This additional value, or latent value, will affect the choices of market participants (e.g., buyers, sellers, investors, and developers) and the approaches used in the estimation of value. If this potential is ignored, the property could be substantially undervalued. Alternatively, if the potential is misunderstood or overstated, the property could be substantially overvalued. Again, the potential use must be reasonable.

The latest edition of The Appraisal of Real Estate references reasonably probable; however, no definition is provided. This is likely because reasonably probable can mean many things depending on the scope of the assignment. That said, we have found that by providing a base level or foundation for our understanding of the term, we have gained a better appreciation for it. Going to the root of the two words:

“Reasonable” is defined as, “being in accordance with reason; having the faculty of reason; or, possessing sound judgment.”³

Whereas, “probable” is defined as, “supported by evidence strong enough to establish presumption but not proof; or, likely to be or become true or real.”⁴

The key is that we are not trying to determine what the highest value could be without constraints. We are trying to determine the highest value the market would likely achieve and how it might go about doing so. We are attempting to replicate market behaviour and, therefore, we must understand the constraints the market itself faces. As property tax experts, if we are not replicating reality, we are fabricating fantasy.

With that in mind, when combined, we can synthesize our understanding of reasonably probable to:

A conclusion of the property’s use supported by sound appraisal judgment and market evidence, which is strong enough to establish the likelihood of becoming true or real.

Highest and best use requires looking to the future and considering what is reasonable and realistic, what is not only possible but probable. This involves understanding the potential for rezoning, if any, and the market demand or potential for a proposed new use. In hiring a competent professional relying on sufficient information, evidence, and analysis, a prediction advances from a guess to a forecast, from a crystal ball to a reasoned decision, from speculative to reasonably probable.

The determination of the highest and best use provides the basis for the research and analysis of comparable sales, as a property with a different highest and best use is clearly not comparable and, thus, not relevant. If you are selling your house, and you know it has development potential, then you would set your price expectations based on what similar redevelopment properties are selling for; relying on sales with no redevelopment potential would likely undervalue your home.

Concepts, Terminology, and Timing

People new to highest and best use can find the terminology and concepts vague and confusing: realistic versus reasonable, potential versus possible versus probable, reasonably near future versus foreseeable future versus in the future, prediction versus speculation, and so on. All these terms may have a simple definition but are loaded with meaning.

For example, what is speculation? This is an expected and accepted part of real estate development, investment, and sales, but the term has a negative connotation in valuation. It implies a lack of objective basis or market behaviour that is perhaps irrational and unreliable. Similarly, what is the future? A land use planner may define the future using population and demographic trends looking ahead 50 years or more. On the other hand, a property tax assessment may consider only one to three years as appropriate for the foreseeable future or reasonably near future. Maybe a lender considers 10 years, which coincides with the term of the mortgage financing in mind, to be the most appropriate measure of the future. This raises the question: whose time is it anyway?

Note: "Assessment" means a valuation of property for taxation purposes.

Source: H & C Johnstone, Presentation for UBC, CPD 105.

As you go from left to right in the example above, the analysis changes and the timeframe and the level of speculation narrow. A city planner may speculate based on forecasting various key indicators, such as demographics, for the best future possibilities upwards of several decades. A developer’s goal may be to achieve the greatest return in 2 to 10 years by maximizing the buildable area based on the current permissible density or speculating on a higher density or use beyond current limits. An assessor’s timeframe, however, may be bound by legislation or case law.

Professional property tax appraisers must understand speculation, but it is not their role to speculate. For example, “reasonably probable” has an inferred meaning from property tax case law to be greater than a 50% probability. Accordingly, conclusions of highest and best use must be reasonably probable, supported by market evidence, with the likelihood of becoming true or real – as opposed to being speculative.

Remembering to Forget

To add further complexity, property tax specialists face another challenge: how to unlearn the known. Retrospective reports are common in estate planning and taxation. What they say is true – nothing is certain but death and taxes. Many taxing jurisdictions are cyclical and retrospective. A retrospective appraisal is complicated by the fact that the author already knows what occurred in the market after the valuation date. In preparing a retrospective valuation, it is recommended that hindsight or after-the-fact evidence not be used unless the subsequent data is consistent with the data as of the valuation date (i.e., an ongoing trend that is established prior to that date).

For example, currently, Ontario is in year eight of what’s normally a four-year cycle based on a historical valuation date of January 1, 2016. Going back to the future, what if the current assignment was a market value report for a potential redevelopment site in 2024 but as of a 2016 valuation date. As property tax professionals, we keep up to date on our analyses and data research, so we would know today what we could not possibly know in 2016. For example, for this potential redevelopment site, what was knowable in 2016? We would know the zoning in place. We would have access to the municipal plan, neighbourhood plan, or even a site-specific plan if there was one. We could contact the city planning department to see if there were any municipal meetings on this site. Even today, we could search the internet for news articles on the site as many articles covering developments often linger. We could review the comparable sales that took place around the valuation date. We could speak to our client(s) about their motivations and logic at the time of purchase. We could review earlier valuation reports written during this timeframe. These are things market participants would have known with certainty and can be referenced in retrospective valuations.

Why is this important? How many times have you said: “If only I had known then what I know now, I would have…” The prevailing trend has seen upward pressures on densification and increased density in most urban areas. However, is it acceptable to base a “fair and equitable” property tax assessment using what was knowable in the future—the trend toward higher densities—to determine an appropriate assessed value for a retrospective valuation date? While acquiring knowledge from time-travel is acceptable for characters in science fiction novels and television shows, transporting previously unknowable information back in time when performing a retrospective valuation is not appropriate.

At Ryan, we have specialized valuation experts who can handle all the highest and best use challenges for all your real property tax needs, whether a current, retrospective, or prospective valuation is required.

Charles Johnstone
Principal, Expert Witness Services
charles.johnstone@ryan.com

Haydn Johnstone
Director, Property Tax Complex
haydn.johnstone@ryan.com

¹ Portions of this article previously appeared in CPD 105 - Highest and Best Use Analysis, Real Estate Division, UBC Sauder School of Business (sauder.ubc.ca/programs).  Reprinted with permission.  See also: Johnstone, Charles and Haydn C., “An Understanding of Reasonably Probable That is Probably Reasonable,” Insti-News, Spring 2024, Institute of Municipal Assessors (issuu.com/theima/docs/spring_2024_insti-news_v4).

² The opposite may also be true, think of neighbourhoods or towns that are located where employment no longer exists.

³ https://www.merriam-webster.com/dictionary/reasonable, Merriam-Webster (2024).

⁴ https://www.merriam-webster.com/dictionary/probable, Merriam-Webster (2024).