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I wrote a number of articles talking about the different factors which could affect an appraisal – for instance, its condition, feature, and neighborhood. However, one thing I haven’t touched on is whether the real estate transaction is an arm’s length or not. I also noticed that some appraisers might not verify this info in their usual practice.
So what is meant by Arm’s Length Transaction? An arm’s length transaction is that both the buyer and seller are unrelated to each other. Their decision is merely based on maximizing their own interest. They have no interest in the other party’s benefit.
In this post, I’ll talk about the different interpretations of the arm’s length transaction among entities, why does it matter, what are some guidelines to handle non-arm’s length assignments.
Different Definitions of Arm’s Length Transaction Lead to Confusion
I’ve done a bit of research. It seems that appraisers have different interpretations of what constitutes an arm’s length transaction. The complication could be due to the different wordings of its definition provided by various entities.
For instance, FHA seems to place greater emphasizes about meeting the market value.
An Arm’s Length Transaction refers to a transaction between unrelated parties and meets the requirements of Market Value.
Quote from FHA Single Family Housing Policy Handbook
On the other hand, according to the book, The Appraisal of Real Estate 13th Edition, the Appraisal Institute defines an arm’s length transaction is as one between unrelated parties under no duress.
Whereas another book, Fundamentals of Real Estate Appraisal has a thorough definition which includes the access of information.
“A transaction in which both buyer and seller act willingly and under no pressure, with knowledge of the present conditions and future potential of the property, and in which the property has been offered on the open market for a reasonable length of time and there are no unusual circumstances.”
Quote from Fundamentals of Real Estate Appraisal 8th Edition
4 Principles in Determining an Arm’s Length Transaction
Principle#1: No relationship
Family Relationship: The obvious non-arm’s length transactions that most people could think of is when a buyer and a seller are family members or relatives. This could significantly influence the selling price, terms, and conditions of the agreement. For instance, when a mother is selling a house to her daughter, she could be selling it at a discount to her.
Business Relationship: Suppose you are a major shareholder of a private company. Your business partner might consider selling their property to you with favorable terms and price since there are other business dealings involved.
In some cases, a corporation owner could even be selling a property to himself, under his personal name.
Principle#2: Buyer and seller are acting in their own interest
In an ideal arm’s length transaction, a seller would want to sell their property at the highest price, whereas a buyer would want to pay as little as possible. When everyone is putting their interest as a priority, they would eventually come to a fair price and terms which both can agree.
However, there must not be any duress during the process. The contract would not be valid if someone is forced or threatened into signing it.
Principle#3: Access to information about the property
Both buyer and seller should have knowledge about the present conditions and future potential of the property. For instance, the potential buyer would have information about its structure, size measurement, age, property tax, prices of similar properties in the neighborhood. These details can often be found on the MLS listing or can be obtained from the seller’s agent.
Buyer and seller can only make their informed decision when there is access to sufficient data.
Principle#4: Meeting market value
The first three principles are to ensure that the buyer’s and seller’s decision is independent, informed, and rational. Ideally, this would lead to a price which could reflect the market situation.
Requirements of Arm’s Length Transaction Can be Mutually Exclusive
I talked to several appraisers, and they stated that the four principles outlined have its limitation. It’s straightforward to find out if the buyer and seller have any relationship. But some do not agree that the market value needs to be met. Let’s consider the following scenarios:
- A grandma is selling her house to her grandson at the market price.
- A buyer is purchasing a property at a significant discount. However, he is totally unrelated to the seller; it just that the seller is urgently in need of money.
In the above cases, would you consider the transactions to be an arm’s length or non-arm’s length?
Since the wording of its definition varies across different books, you should review the guideline of the lender’s who is ordering the appraisal or the State Appraisal Board. For instance, for FHA appraisal, you could check the FHA Single Family Housing Policy Handbook.
What’s the Big Deal About Arm’s Length Transaction?
Higher lending risks
Some lenders are more cautious when leading to non-arm’s length real estate transaction. Suppose a person is selling his property at a price way beyond the market value to another family member and a mortgage lender finances the majority of the funding for the purchase. Should the mortgage default, the lender could suffer huge losses since the purchase price was over-inflated.
To minimize the impact of such events, FHA loans can only finance up to 85% Loan-to-Value ratio in a non-arm’s length transaction. In most cases,
an independent appraisal is required during the underwriting process.
(If you want to know more about FHA appraisals, here’s a post for you.)
Misleading comparable
The impact of non-arm’s length transactions do not just affect the subject property, but when they are used as comparable, it could lead to a very different result.
For example, suppose all the comparable you choose happens to be sales between family members (i.e., retired parents selling their homes to the adult children). The sales price could be at a significant discount, which would mislead you to an appraisal value that is way off from the market price.
I knew that there had been a case where a vacant land was sold at an substantially over-inflated price. It turned out the developer merely sold the lot to himself in attempting to create comparable sales.
This is why lenders tend to encourage the use of arm’s length transactions when doing the comparison.
The Appraiser must utilize Arm’s Length Transactions for comparable properties except when there is evidence that REO sales or short sale/PreForeclosure Sale (PFS) transactions are so prevalent that normal Arm’s Length Transactions are not present or supported by the market trend
Quote from FHA Single Family Housing Policy Handbook
How to Handle Non-Arm’s Length Appraisal Assignment?
1) The first thing you should do is to verify whether the subject property or comparable are arm’s length or not. Many appraisers failed to take this step. All you have to do is to confirm this information with the real estate agent who is handling the deal.
2) If using non-arm’s length comparable is unavoidable, then you need to specify this in the appraisal report with detailed explanation. Under the new UAD requirements, appraisers must identify whether the sale is a short sale, court ordered, REO, relocation, non-arm’s length transaction, arm’s length transaction or a listing.
To give you a better idea, below is a quote from the FHA 4000.1 Handbook.
In some markets, non-arm’s length sales constitute the majority of recent transactions of similar properties and thus are significant in the analysis of the subject. This assignment is to estimate Market Value, so REO sales, short sales and other nonarm’s length transactions must not automatically be chosen as comparables. If there is compelling evidence in the market to warrant their use, the Appraiser must provide additional explanation and support in the “Analysis” section of the sales comparison approach.
Quote from FHA Single Family Housing Policy Handbook
3) Review the guideline from the lender and see what specific requirements do they have for dealing with non-arm’s length transactions. Also, check with the State Appraisal Board to make sure your work complies with their rules.
Related Questions
1) What are the tax consideration for non-arms real estate transaction?
Although some non-arm’s length transaction could have a lower price, the tax agency in some states could require the seller to pay tax for the full gain as if the property is sold at market price.
Similar tax treatment might apply when it involves an international sale. This usually happens when a property is sold between two non-arm’s length companies — for example, two subsidiaries with the same parent company. One firm is selling a property to another outside the country.
This tax treatment prevents the company from avoiding paying tax on the realized gain.
However, since I’m not an accountant, and tax topics are beyond my expertise. I’m just writing this as a piece of general information. You should always consult with an accountant regarding that.
2) Beside arm’s length transactions, what other factors can affect the appraisal value?
Other factors such as property size, age, features, condition, quality of the neighborhood, external obsolescence, functional obsolescence can all affect the appraisal value.
Here are a few articles which you might useful:
Conclusion
As a professional real estate appraiser, you must consider different factors which could impact the appraisal value. Reviewing the property’s history of transactions is necessary.
Whether the comparable is in an arm’s length transaction or not could have a considerable impact on your result. In an arm’s length real estate transaction, the parties would be unrelated to each other and that they are only acting in their best interest.
When there is uncertainty, you should ask questions to the real estate agents or the loan officers who are involved in the buy-sell process. Only through detailed information and careful analysis, you could then accurately generate the appraisal report for your clients.
Disclaimer: The information in this post is for general information only, and not intend to provide any advice. They are subjected to change anytime without notice, and not guaranteed to be error-free. For full and exact details, please contact the Appraisal Board in your state, the education or service provider.
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