How often do we appraisers get into the mode where we think we know it all? Occasionally, do we need to step back and look at the way we do things, just to make sure we are not missing something? Is what we know to be true and correct really true and correct? I raise this issue relative to the concept of what an arm's-length transaction is. Are we truly aware of its definition and its application?
I thought such a transaction was one where the buyer and seller were traditionally motivated; there was no coercion, no bias; no relationship between the parties. In other words, it was a typical market transaction. This is how this concept was taught to me when I took my original appraisal classes, oh so long ago. This is what my mentor taught me. However, was that correct? Let's go to USPAP to see what it says.
Surprisingly, USPAP does not define the term arm's-length transaction. Fannie Mae also lacks such a definition. Yet, both of them call for the appraiser to use only arm's-length transactions as comparable sales (which is what the definition of market value assumes). Now, consider a situation in which a tenant in a duplex is the contract grantee. Your client gives you a copy of the tenant's current lease, as well as a copy of the signed and executory purchase and sales agreement. With those data only, how do you conclude if this is an arm's-length transaction?
Let's assume, for the purposes of this discussion, that some analysis on your part reveals that this property was never offered for sale via the local MLS. Further, the tenant as the contract-grantee might have had some "sentimental" reasons to purchase the property (although I can't imagine about how anybody could get sentimental about a duplex property), thus may have other-than-market motivations to purchase. Therefore, based on this analysis, at one time I would have concluded this was NOT an arm's-length transaction.
In all candor, however, I can't say this question would be so cut-and-dried to me now. For example, what if the seller offered the property for sale as a FSBO? True, there was no exposure via the local MLS, but why does a property need to be offered for sale via the MLS just to qualify as having been "…offered for sale on the open market"…? Next, where is it written that a tenant-purchase of a duplex cannot/does not meet the requirements of an arm's-length transaction? Why assume that merely because the tenant is the contract grantee, the parties to the contract reached that sales price by other than free and open negotiations?
From the seller's standpoint, in this scenario, is there any evidence the seller is under any undue influence to sell the property (to anybody, including the tenant)? So, if there is no undue influence to sell, as well as no undue influence to buy, and the parties arrived at the contract price via free and open negotiations, what is not arm's-length about this transaction? Without reading any more into this scenario, nor reading anything out of it, I see this transaction as arm's-length for these reasons. Could I change the scenario to make it a non-arm's-length transaction? Yes. However, that's not the point here.
Now, here is another question: who determines if the sale is arm's-length? Consider this true story. A grandchild offers to purchase a grandparent's property. Both the grandparents and the grandchild have the property appraised, and then from those appraisals negotiate a purchase price and terms. The grandchild will put 10% down, while the grandparents will not carry any paper. It's the same deal as any buyer could make. The only difference is that a grandchild bought the property from a grandparent. Now, is that an arm's-length transaction?
Some will say yes, whereas some will say no. However, the point is not whether it is or is not. The point is the appraiser cannot answer that question until after having completed the necessary analyses to determine its status. Frankly, I say it is an arm's-length transaction but would understand if another appraiser, faced with the same circumstances, would say no. This is why we must confirm sales with other than MLS. It is only after the proper analyses that we can make this decision. Proper verification of this transaction is more work than we would normally do, frankly, since, typically, such a buyer-seller situation does not come up all that often. Nevertheless, to verify if this sale in a comparable is work we need to at least attempt to do. It's our job to analyze any given transaction, and then decide if it is or is not arm's-length. If the details of a specific transaction are too cloudy to make the decision, then we may decide to get another comp.
The purpose of this blog is not to define an arm's-length transaction. Rather, its purpose it to make sure we as appraisers know that determining this is part of what we do - the verification part. And because it is part of what we do, we have the freedom and responsibility to determine which comparable sales to use and which to reject. We do this, in part, by learning enough about a sale and purchase transaction to determine if it is or is not an arm's-length transaction.
For more information on this subject, please listen to The Appraiser Coach Podcast Episode:
