Highest and Best Use

While teaching, a student who has been appraising real estate for years, recently asked “why business appraisers rarely discuss the concept of “highest and best use”. An excellent question. “Highest and best use” is the legally permissible application of an asset that will yield the greatest economic benefit to its owner. If you own vacant land, some potential highest and best uses might be a parking lot, apartment building, or oil well (if there are proven reserves). A real estate appraiser will consider, assess, and discuss these in every appraisal, usually at the very beginning of their report. This occurs because:

  1. Most real estate appraisals involve “100% fee simple interests”, meaning that they assume that the subject property has a single (control) owner and that there are no encumbrances (such as debt or other use restrictions). Control owners are obviously free to seek the highest and best uses of their properties, and the asset values reflect that freedom.

  2. Many business appraisals involve minority interests. This introduces three levels of complexity: the standard of value, the premise of value, and the level of value. Each constrains the ability of the minority owner to realize the “highest and best use” value of the underlying business assets.

  • The level of value: Minority owners do not have the power to control how business assets are deployed. Minority owners of marginally profitable or money-losing businesses, except in cases of shareholder oppression, cannot force the controlling owner to (for example) reduce his/her compensation in order to create more distributable earnings; i.e., to create higher and better use of the assets employed.

  • The premise of value: In the same vein, minority owners of such businesses cannot force the owners to liquidate, even if a higher value could be obtained compared to continuing in operation.

  • The standard of value: Most business appraisals involve fair market value – the value to any willing buyer and seller – not the value to a strategic buyer who might be able to pay a higher price. Strategic or synergistic value is not part of the fair market value, and the minority owner cannot force the controlling owner to seek such buyers in order to realize that value.

Each of the three complexities - level, premise and standard of value - is clear when valuing minority interests. When valuing control (or 100%) interests, they are also relevant:

  • Control ownership discretionary expenses are “added back” (normalized), since a buyer would not necessarily incur them. But there are more complications: if the business is not operating as efficiently as possible (based on benchmarking with its peers), the appraiser will have to assess whether such improvements are feasible and probable.

  • The higher of going concern versus liquidation value applies, since a rational control owner would not want “lowest and worst use”.

  • If the appraisal is for tax purposes, the fair market value standard applies (no strategic buyers are considered), but if the appraisal is for sale purposes, the strategic value becomes paramount.

The bottom line is: although highest and best use is a fundamental concept for all appraisals, it is much easier to address in real estate appraisals than it is in business appraisals. Valuations play a part in all tax, transaction, and litigation matters. For additional information or advice on a current one, please do not hesitate to contact us. We Value Your Business!