Highest and Best Use

Highest and best use is the reasonably probable use of a property that is legally permitted, physically possible, financially feasible and produces the highest value. Appraisers test it before valuing anything. A cap rate on current NOI assumes the current use is the best one, which is not always true.

On a lot zoned for eight units, a small house may be worth less as a rental than the land is on its own. In that case its cap rate on current rent is not a useful guide to value, because a developer would pay for what the lot could hold. Old buildings in growing areas often trade this way.

The reverse also happens. A property with high current NOI but no legal right to its use, such as an unpermitted unit, is worth less than its cap rate suggests. Check zoning and permits before capitalizing income that depends on them.