Eleven Types of Risk in Commercial Real Estate

Every investment involves a certain amount of risk. There are certain general sources of risk that influence all assets – things like geopolitical risk and global macroeconomic risk. What makes each asset unique is the level of sensitivity that its rate of return has to those risks. In addition, specific types of assets have risks that are uniquely their own. In this article, we’ll look at eleven types of risk in commercial real estate investment.

Credit/Default Risk

Credit risk, or default risk, is the risk that someone will not be able to meet a financial obligation. Lenders face default risk that a borrower will not be able to make a monthly loan payment on time. Similarly, leased property includes a risk that tenants will not be able to make timely lease payments as expected. Late payments can create cash flow problems for the property owner, but the situation can be worse if the tenant goes out of business and moves out of the space. Then, the property owner faces an unexpected shortfall in lease income along with additional costs to get a new tenant in the space.

Inflation Risk

Inflation is the general increase in prices and decrease in purchasing power that happens over time. In the United States, the inflation rate has been around 2% per year since the year 2000. So, planning for 2% inflation each year would be a reasonable estimate in this market. Property owners, therefore, can set lease rates that allow for this 2% annual growth in overall market prices. Inflation risk, however, is the risk that this expectation is wrong. What if a tenant just signed a 10-year lease with an expectation of 2% inflation, but one year into that lease inflation goes up to 12% annually? The tenant ended up with a pretty great deal, but the property owner may not be able to keep up with the rising cost of operating expenses if inflation rates are this much higher than expected.

Macroeconomic Risk

Macroeconomic risk refers to how broad, national level economic activity impacts property cash flows and valuation. For example, during a period of high growth in GDP, most businesses have ample cash on hand and low unemployment. Property owners can increase rental rates and expect low vacancy rates and collection loss. These factors also cause property valuation to increase. On the other hand, businesses may struggle to stay in business during a recession, and unemployment rates increase. Property owners may have a more difficult time collecting rent on time from tenants, and in the worst case have tenants go out of business entirely. Vacancy rates increase, and finding a new tenant is challenging. These factors all result in lower property valuations.

Interest Rate Risk

The type of interest rate risk that most people worry about is the risk of increasing interest rates. Borrowers holding a mortgage with a floating interest rate are negatively impacted by rising interest rates. As interest rates increase, so do the monthly mortgage payments. Borrowers could also be negatively impacted by higher rates when refinancing debt at the end of a loan term.

Rising interest rates also impact the net present value of investment cash flows. When market interest rates increase, the required rate of return or discount rate also increases. This change causes the present value of future cash flows to decrease. In some cases, this can result in the cash flows no longer creating an acceptable return for an investor.

Liquidity Risk

Real estate is a highly illiquid asset. A liquid asset is one that can be sold immediately at market value. If an owner had to sell a piece of real estate by the end of the day, chances are that it would be for a price far below market value. So, real estate is illiquid compared to most other types of assets. The degree of illiquidity varies according to location, property type, and market cycle.

Legislative/Regulatory Risk

Legislative or regulatory risk refers to any change in regulations or law that can impact real estate owners or tenants. These changes may take place at the local level or the national level. These may include direct risks such as zoning changes, building codes, or access to public goods and utilities. More indirect risks could be changes to local or federal tax rates, mortgage deductibility requirements, banking regulations, etc.

Increases in tax rates not only impact the property owner’s taxable income but also cash flow of the tenants. Additional limitations on mortgage deductions on federal taxes reduce the property owner’s after-tax income and the overall rate of return on the investment. Changes to bank regulations could influence the cost of borrowing and ease of obtaining financing for a property owner. Even if changes to laws and regulations do not directly impact real estate, they may indirectly impact property investment through financing or business cash flows.

Location Risk

Real estate investment ultimately depends on having the right type of property in the right location. Cities, however, act as dynamic and evolving organisms. What is a prime location for office and retail space today may be empty 20 years from now. Location risk comes from the external environment and the contribution that the neighborhood makes to a property’s value. Changes in city growth or transportation patterns or reductions in public goods and services can all negatively impact the desirability and value of a particular property.

Space Market Risk

Property owners purchase real estate with a specific expectation about market rental rates and the demand for space over the investment holding period. Space market risk refers to the probability that those expectations are incorrect. As an example, consider the potential impact of a global pandemic on long-term corporate behavior with respect to remote working. If corporations suddenly start allowing a large percentage of workers to engage in remote working contracts, the market demand for office space will dramatically decrease from previous forecasts. This unexpected change in demand conditions is space market risk and uniquely impacts real estate assets.

Construction Risk

Any time a property undergoes construction, there is an additional source of risk to the property owner. Construction risk applies whether there is a new development or a significant renovation. The construction project may take longer than expected and delay expected rental income, cost more than the budget estimate, or expose previously unknown defects in the property that require additional time and expense to remedy. All of these scenarios result in a reduction in expected cash flow for the property owner.

Environmental Risk

Environmental risk can come from land use regulations and environmental protection concerns. It can also come from the environmental conditions of a property. The first type of environmental risk can be hard to anticipate and to mitigate. The second type of environmental risk may be limited with a thorough inspection of the property and all historical records about the prior use of the land. Specific environmental risks vary a bit with the region but may include problems such as asbestos and lead-based paints, radon or other hazardous chemicals, groundwater or soil contamination, wetlands, and protected wildlife. Environmental mitigation can be extremely expensive, so property owners should take the time to do their due diligence about potential sources of problems.

Even the nicest property in the best location can be an unprofitable investment without the right management. Property managers establish relationships with tenants and make decisions about lease rates and concessions as well as the operating budget. Poor management can result in high vacancy rates, below market rental income, and high operating expenses. All of these factors reduce the property income for the owner and the return on investment. Thus, knowledgeable and competent property management is essential to success in real estate investment.

Conclusion

Investment commercial real estate has many risks that must be weighed against potential returns. In this article we discussed eleven types of risk in commercial property. These include credit/default risk, inflation risk, macroeconomic risk, interest rate risk, liquidity risk, legislative/regulatory risk, location risk, space market risk, construction risk, environmental risk, and management risk.

 

 

Source: Eleven Types of Risk in Commercial Real Estate

https://www.creconsult.net/market-trends/eleven-types-of-risk-in-commercial-real-estate/

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Off-Market Multifamily Sellers Are Leaving A Ton Of Money On The Table

Off-Market Multifamily Sellers Are Leaving A Ton Of Money On The Table

Marketing a property can increase the sale price by up to 23%, which runs counter to the idea that off-market deals can achieve higher values because a buyer will be more aggressive to seal a trade.

The perception is when a seller has one buyer vying for an asset, that buyer is more aggressive and willing to pay a premium because they don’t want the seller to get into a bidding war for the property. Our research found the opposite.

This is a sign it is in the best interests of owners to undergo a marketing campaign for their properties. Growing allocations from institutional investors toward real estate are still driving a sizable pool of investors into bidding for multifamily assets, and a full campaign is what drives the premiums.

The job of a broker to create a competitive environment on behalf of the seller. Putting a building on the market determines the strongest buyer.

That may not be necessarily based on price alone. If one buyer has a higher-priced offer but weak financial backing, versus a buyer with a stronger track record, taking a lower offer is the way to go. It’s our job to give the seller those options and we do that by marketing properties and generating the highest number of qualified offers possible.

There are numerous case studies where a seller received an off-market bid, put it on the market, and the off-market buyer still bought the asset but at a higher price.

 

Have you thought of selling your property and would like to know what it's worth? Request a valuation for your property below:

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eXp Commercial Chicago Multifamily Brokerage focuses on listing and selling multifamily properties throughout the Chicago Area and Suburbs.

We don’t just market properties; we make a market for each property we represent. Each offering is thoroughly underwritten, aggressively priced, and accompanied by loan quotes to expedite the sales process. We leverage our broad national marketing platform syndicating to the top CRE Listing Sites for maximum exposure combined with an orchestrated competitive bidding process that yields higher sales prices for your property.

 

https://www.creconsult.net/market-trends/off-market-multifamily-sellers-are-leaving-a-ton-of-money-on-the-table/

How The Loss to Lease Calculation Works

Loss to lease is a commonly used calculation in a commercial real estate analysis. However, loss to lease can also be one of the most confusing calculations to understand, especially when you see it for the first time. In this article, we’ll take a closer look at the loss to lease calculations and walk through several examples to help you understand what it is and how it works.

Loss to Lease Defined

Loss to Lease is defined as the difference between a property or unit’s market lease rate and the actual lease rate.  For example, if the market rental rate is $1,000 per month and the actual lease rate is $900 per month, then loss to lease is calculated as the difference between market rent and actual in place rent, which is $100 per month.  When market rent is higher than actual in place rent, then there is a loss to lease. When market rent is lower than actual in-place rent, then this is sometimes called a gain to lease.

The “loss” isn’t realized in the sense that the property owner is required to pay the difference. It’s more of an “opportunity loss” that can act as a leading indicator of two possible situations.  On the positive side, a loss to lease may indicate that submarket rental rates have grown faster than the individual property, so there may be room to increase rents.  Or, on the negative side, it may be an indicator that something is lacking in an individual property (relative to the market) that prevents it from achieving full market rates.

Loss to Lease: Why it’s Important

Loss to Lease is an important concept to consider under two circumstances:

Acquisition Due Diligence:  Often, when a seller or broker is marketing an income producing property, they’ll include two income figures in the proforma:  (1) In-place rents; and (2) Market rents.  If there’s a big difference between the two figures, it may indicate an opportunity to raise rents.  Because commercial properties are valued on cash flow, the ability to raise rents is closely correlated to increasing the value of the property, which can bode well for a profitable exit.

Property Performance:  For property owners evaluating the performance of a property they already own, a big difference between market rents and actual rents may be an indicator that there’s an opportunity to manage the property more efficiently by negotiating higher rents when leases come up for renewal.  Or, it may indicate that there’s something holding the property back from achieving full market rents.  In such cases, improvements or renovations may be required to bring the property condition, finishes, and amenities up to market standards to justify market rents.

It’s important to note that rent increases don’t happen all at once. Leases expire at different times throughout the year, and long-term leases may not expire for multiple years. So, the opportunity to close the gap between market and actual rents occurs slowly over time.  To illustrate this point, an example is helpful.

Loss to Lease Example

Assume that a multifamily property with the following characteristics is being evaluated for acquisition:

• Units:  50
• Avg. In Place Rent:  $800 per unit
• Avg. Market Rent:  $1,000 per unit

Based on these characteristics, the following income figures can be imputed:

The Gross Potential Rent at the existing price is $50,000, which is 50 units multiplied by the market rate of $1,000 per month.  At the time of evaluation, this is the maximum rent possible at the market rate.  However, units are currently renting $200 below the market rate, which represents a “loss” on the leases in place.  Multiplying the $200 per unit loss by 50 units results in a “Loss to Lease” of $10,000.

An investor may look at this deal and think that there’s a 20% rental upside, which is an attractive prospect.  But, an investor can’t acquire a property and raise all the rents on day 1.  They’ll need to do it slowly over time as leases come up for renewal.  To illustrate the effect of this, assume that the investor can “turn” 10 units a year to the market rate.  Over 5 years, the income may look something like this:

Assuming that market rent stays the same over the 5-year period, “turning” 10 units a year reduces loss to lease by $2,000 annually.  Taking the example one step further and building out the remainder of the proforma, assume that expenses for the property and cap rates remain the same over the 5 years:

By assuming that expenses and cap rates remain the same over the 5 ye5-yearar holding period, it can be seen that the value of the property rises solely because reducing loss to lease results in higher NOI, and therefore a higher property value.

Loss to Lease: Raising Rents

In theory, the idea that rents can be raised to be commensurate with the market is simple.  In practice, it isn’t always as easy, and it’s not without risk.  Every time an owner goes to raise the rent, they run the risk that they’ll raise it beyond the tenant’s ability to afford it or beyond their perceived value of the unit, causing them not to renew the lease.

In such cases, the owner now has to deal with a vacant unit that isn’t producing any income, which nullifies the entire premise that a high Loss to Lease presents an opportunity for an investor.  It’s important to consider the balance between raising rents to improve profitability and not driving away tenants with higher prices.

Summary and Conclusions

In this article, we discussed loss to lease in commercial real estate. We defined loss to lease, explained why it is important, and then walked through an example where loss to lease was reduced slowly while expenses and the cap rate remained unchanged. This showed how reducing loss to lease over time can increase the value of a property.

Granted, it’s unrealistic to expect market rents, expenses, and cap rates to remain unchanged over a 5-year span, but this article demonstrates there’s always going to be a difference between market rents and actual rents and the term for this difference is known as loss to lease.

While loss to lease isn’t a complicated calculation, creating an apples to apples comparison to determine true market rents requires detailed analysis to ensure that the properties surveyed are similar to the subject in location, finish, and amenities.

A large loss to lease is an indicator of potential mismanagement and an opportunity to raise rents and therefore raise the value of the property.  However, rents usually can’t be raised quickly, simply, and to 100% of the market value.  Raising rents too high can cause a tenant to not renew their lease, creating a vacancy that the owner may or may not be able to quickly re-lease at the market rate.

 

 

Source: How The Loss to Lease Calculation Works

https://www.creconsult.net/market-trends/how-the-loss-to-lease-calculation-works/

The Income Approach to Real Estate Valuation

The income approach is one of three techniques commercial real estate appraisers use to value real estate. Compared to the other two techniques (the sales comparison approach and the cost approach), the income approach is more complicated, and therefore it is often confusing for many commercial real estate professionals. In this article, we’ll walk through the income approach to property valuation step by step, including several income approach examples.

What is the Income Approach to Valuation?

The income approach is a methodology used by appraisers that estimates the market value of a property based on the income of the property. The income approach is an application of discounted cash flow analysis in finance. With the income approach, a property’s value today is the present value of the future cash flows the owner can expect to receive. Since it relies on receiving rental income, this approach is most common for commercial properties with tenants.

There are two methods for capitalizing future income into a present value: the direct capitalization method and the yield capitalization method. The difference is that the direct capitalization method estimates value using a single year’s income, while the yield capitalization method incorporates income over a multi-year holding period. Let’s take a look at both methods in some more depth.

Income Approach: The Direct Capitalization Method

The direct capitalization method estimates property value using a single year’s income forecast. The income measure can be Potential Gross Income, Effective Gross Income, or Net Operating Income. Direct capitalization requires that there is good, recent sales data from comparable properties. The comparable sales provide the appropriate market multiplier to use with the subject property. You can find the average market multiplier after finding reasonable comparable sales data. The following formulas are three ways to find the market multiplier using different measures of income:

1. Potential Gross Income Multiplier (PGIM) = sales price / PGI
2. Effective Gross Income Multiplier (EGIM) = sales price / EGI
3. Net Income Multiplier (NIM) = sales price / NOI

After finding the market multiplier, multiply the subject property’s forecasted income by the market multiplier. For example, multiplying the market PGIM by the subject property’s forecasted PGI in the next year yields the current subject value estimate. Direct capitalization requires that the income and expense ratios are similar for the comparables and the subject property and that the next year’s income is representative of future years.

Appraisers often use the capitalization rate, rather than income multipliers, to estimate market value using a single year’s income forecast. The capitalization rate is the inverse of the Net Income Multiplier. In other words, it is the ratio of a property’s Net Operating Income to its value.

Income Approach: The Yield Capitalization Method

The yield capitalization method is a more complex approach to valuation. This method uses net operating income estimates for a typical investment holding period. Therefore, the resulting property value accounts for future expected changes in rental rates, vacancy, and operating expenses. Yield capitalization doesn’t require stable and unchanging market conditions over the holding period. The yield capitalization method also includes an estimate of the expected sales price at the end of the holding period. Let’s take a closer look at how the yield capitalization method works.

Components of the Yield Capitalization Method

Using the yield capitalization method, the subject value estimate is the present value of the future expected cash flows. The present value formula simply sums the future cash flows (P) after discounting them back to the present time. Applying this formula, the cash flows are the proforma estimates of net operating income (P₁through P_n), the required rate of return is r, and n is the holding period. Although the formula calculates present value (PV), it should be noted that both Excel and popular financial calculators utilize the net present value (NPV) formula to find the present value of uneven cash flows. This works because you can simply plug in $0 for the initial investment amount, and then the resulting net present value amount will equal the present value.

Here are some more details on the components of the yield capitalization method:

• Cash Flow Forecasts. Forecasting the cash flows that an income-producing property will generate over the next year is relatively straightforward and accurate. Properties already have tenants with leases in place, and costs should not vary dramatically from their current levels. The more challenge part of cash flow forecasting comes when considering what happens to cash flows over the next couple of years. In addition, any forecasting errors in one year tend to compound themselves in the subsequent years. Holding periods of 5–10 years are the most common, and those estimates require forecasting future market rent, vacancy and collection loss, and operating expenses.
• Resale Value. Calculations using the income approach assume that the owner sells the subject property at the end of the holding period. Appraisers can estimate resale value using a direct dollar forecast or an average expected annual growth rate in property values. Direct dollar forecasts are not preferred because they don’t directly account for any market expectations. Growth rates consider forecasted market growth rates, but the subject property’s value may grow at a rate that differs from the market average. A third method applies direct capitalization techniques to the end of the holding period. For example, an appraiser considering a five-year holding period would extend the proforma cash flow estimates one additional year. The expected sales price at the end of the fifth year would equal the NOI in the sixth year divided by a market capitalization rate.
• Discount Rates. In corporate finance, the discount rate in a net present value calculation is usually the firm’s weighted average cost of capital. When valuing an investment, however, the discount rate is usually represented as the required rate of return. Real estate investors may use the required rate of return on their investment properties or the expected rate of return on an equivalent-risk investment.

Income Approach Example Using Direct Capitalization

One of the benefits of direct capitalization is that it provides a way to get a quick valuation estimate. Appraisers can quickly get a market multiplier from recently sold property transactions. Consider two recently sold comparables, one with PGI of $300,000 and a sales price of $2.1 million and another with a PGI of $225,000 and a sales price of $1.8 million. The first yields a PGIM of 7 ($2,100,000/$300,000) while the second yields a PGIM of 8 ($1,800,000/$225,000). So, the market average PGIM of 7.5 can be applied to a subject property’s PGI estimate to provide a quick valuation. If a subject property’s expected PGI next year is $195,000, multiply that by the market PGIM to estimate the subject value.

Subject Value = $195,000 x 7.5 = $1,462,500

Appraisers also use direct capitalization together with residual valuation techniques to find the value of a property when only the value of the land or the value of the improvements is known. The value of the land may be known from a separate analysis using comparable land sales data. From this analysis, suppose the land value is $350,000 with a 9% land capitalization rate. Further, suppose the improvements alone have a 10% capitalization rate.

The portion of the property’s NOI that is generated by the land can be calculated by multiplying the land value and land capitalization rate. The remaining income is attributed to the improvements.

Dividing the return contribution of the improvements by the improvements capitalization rate results in a valuation of $2,185,000 for just the improvements. Adding the land value to the value of the improvements results in a total property value estimate of $2,535,000.

Income Approach Example Using Yield Capitalization

In order to estimate the subject property value using the income approach, the first step is to create a proforma cash flow statement for the anticipated holding period. Using the following market assumptions, let’s estimate the cash flows to the owner over a five-year holding period.

• The subject property is expected to yield PGI of $200,000 over the next year and currently has a 5% vacancy rate. Operating expenses are currently 45% of EGI, and that is expected to stay the same during the holding period.
• Market rent is currently increasing at a rate of 3% per year. During the second year, however, it is expected to only grow at a rate of 1% before returning to the current 3% growth rate.
• The vacancy rate is expected to climb to 7% during the following two years and then return to a stable 5%.
• The terminal capitalization rate of 9% is estimated from current market cap rates.

This is the proforma cash flow statement under the given market assumptions. The sales price in year 5 is year 6 NOI divided by the capitalization rate.

Now we can compute the present value by discounting the future cash flows back to the present using the investor’s required rate of return of 12%. The cash flows are $104,500 in year 1, $103,323 in year 2, $106,423 in year 3, $111,973 in year 4, and $1,435,241 (the sum of NOI in year 5 and the expected resale value) in year 5. Therefore, the subject value estimate is $1,136,977.

Conclusion

In this article, we discussed the income approach to real estate valuation. We defined the income approach and then explained the two income approach methods appraisers use. First, the direct capitalization method uses a single year’s income to estimate the market value of a property. Second, the yield capitalization method uses a multi-year forecast of cash flows and then discounts these future cash flows back to the present to get a present value for the property. We then walked through an example of both the income approach using the direct capitalization method and another example using the yield capitalization method.

 

 

Source: The Income Approach to Real Estate Valuation

https://www.creconsult.net/market-trends/the-income-approach-to-real-estate-valuation/

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How To Determine The Highest and Best Use of a Property

The concept of highest and best use is one of the fundamental principles that underlie real estate appraisal. Highest and best use requires that the appraisal considers not just the current use of the property but also the potential value associated with alternative uses. The Appraisal Institute has four tests that appraisers can use in order to narrow down all of the alternatives to one highest and best use of the property.

Four Tests for Highest and Best Use

You can use the following four tests to find the highest and best use of a site as if vacant or currently improved.

1. Is the use physically possible?

The first test of highest and best use simply evaluates whether it is possible to use the land in a certain way. Ignoring the zoning and economics of the proposal, consider whether or not the potential use is physically possible. That means the topography, soil type and conditions, lot size and shape, surface and subsurface water, and even weather patterns must make the development possible. So, you probably can’t build a marina in the middle of the desert, a heavy, marble building on soft clay soil, or a building with a 250,000 square foot base on a 200,000 square foot lot. In addition, an appraiser must not only consider the proposed use of the site but also the characteristics of the optimum improvements for that use. This first test, however, is usually the easiest to pass.

2. Is the use legally permitted?

After eliminating any potential uses that are not physically possible, you can move on to the second test. Whether a potential use is legally permissible involves a few different legal considerations. The proposed use must be allowed by zoning regulations. If building in a residential area with restrictive covenants, the proposed improvements must not violate any rules. The proposed use must conform to all applicable building codes and height limits. In addition, the improvements must adhere to any restrictions imposed by easements on the property.

Determining whether a proposed use is legally permitted requires research into the local building regulations and restrictions. Gaining a comprehensive understanding of the applicable legal requirements can be time-consuming, but it is fairly easy to determine whether or not a proposal violates any of these regulations. Concluding whether or not something is legally permissible is a straightforward process. Regulations, however, change over time. An area that was zoned for residential development can be changed to commercial development. Just because a proposed development is not legally permissible does not mean that it will always be that way. In these cases, an appraiser must consider the probability of the legal restriction being changed to allow the proposed development. In these cases, there should be substantial documentation suggesting that the regulation will be changed in order to pass to the third test of highest and best use.

3. Would the use be financially feasible?

To address whether a proposed use is financially feasible, you need to conduct a market analysis and develop proforma cash flow estimates. You’ll need to collect data in order to forecast construction and development expenses, operating expenses, rents, absorption rates, vacancy rates, discount rates, cap rates, and residual values. Once you’ve gathered all of this information, you will estimate the proforma net operating income over your expected holding period. Employing discounted cash flow techniques, you can determine which projects meet your particular investment standards. Discounting cash flows by your cost of capital and computing the net present value, a project is considered financially feasible if the NPV is greater than 0. You can also compute the internal rate of return and compare the property’s return to your acceptable hurdle rate for projects. Only the proposed property uses that meet these criteria for being financially feasible move to the next step of the analysis.

4. Would the use be maximally productive?

The prior steps eliminated proposed uses that were not physically possible, legally permissible, or financially feasible. This final step takes all of the proposed uses that meet these requirements and ranks them in order of value or rate of return. While ranking proposed uses, it is also helpful to consider the risk associated with the proposed use. For example, one proposed use might generate a much higher internal rate of return than all of the other proposed uses. Yet, the reason for the high return may be related to the higher risk of that project. One way to adjust for the risk associated with a proposed use is to apply a discount rate that is commensurate with the level of risk while computing the net present value. In the end, the proposed use with the highest internal rate of return and net present value is the maximally productive use.

Applying Highest and Best Use to an Existing Structure

To illustrate how highest and best use works in practice, consider an old 1920s brick building in the central business district of a small city. Business and residents moved away from the area, and its current use as retail space may no longer be the highest and best use of the property. It is a 15,000 square foot building, and its estimated value as vacant land is $10/sqft, or $150,000.

In its current use as retail space, the property generates rent of $12/sqft. Vacancy rates are around 11% since foot traffic generally doesn’t support retail business in the area. Operating costs are $34,000 per year. Since conditions are fairly stable, capitalizing next year’s income at a rate of 9% yields an estimated property value of $1,402,222.

Another alternative would be to renovate the property and convert it into office space. Market research indicates this is a desirable area for professional office such as attorneys, accountants, architects, and designers. Market rent for offices in this area is $21 per square foot and has been increasing by 2% annually. Operating costs average $5/sqft and increase by $0.25 per year. Converting the property into office space will cost $850,000 in the first year, and average vacancy during the year will be 75% due to the time of the renovations. Vacancy is 20% in year 2 and then settles into a constant 5% thereafter. The resale price of $2,629,402 at the end of the 5-year holding period is calculated by dividing year 6 NOI by a 9% cap rate. The net present value of cash flows discounted at a rate of 10% yields a property value of $1,485,848.

Highest and best use analysis evaluates each potential use of the property and its corresponding value. The vacant property is valued at $150,000. Continuing to use the property for retail space yields an estimated value of $1,402,222. Converting the property into office space results in a value of $1,485,848. Highest and best use analysis, therefore, concludes that the best use of the property is as office space

Conclusion

In this article, we discussed the 4 tests for highest and best use. These 4 tests ask if the proposed use is 1) physically possible, 2) legally permitted, 3) financially feasible, and 4) maximally productive. We then walked through an example of how to apply highest and best use theory to evaluate a property with three potential uses: as vacant land, as an existing structure, and as renovated. via bookmarklet

 

 

Source: How To Determine The Highest and Best Use of a Property

https://www.creconsult.net/market-trends/how-to-determine-the-highest-and-best-use-of-a-property/