As we develop new products for appraisers, compliance with industry standards is always front and center. Our objective is to help improve appraisal quality and provide efficiencies to the process. Everybody wins by connecting industry needs with appraisal reporting techniques through technology, industry guidance, and practical advice. This is ACI’s contribution to the industry – and we hope you find it informative and helpful. Enjoy.
This is the second in a series of blogs on the topic of arm’s-length-transactions, or ALTs. If you have not read the first blog, click here.
The theme of the previous blog is that most definitions of an ALT are consistent that the definition found in the current edition of The Appraisal Institute’s publication The Dictionary of Real Estate, which defines an ALT as “a transaction between unrelated parties who are each acting in his or her own best interest.” This definition provides the context for today’s blog. Note there is nothing in the definition above that references exposure time, listing in an MLS system, distress, duress, or market value.
One explanation for at least some of the confusion regarding the term “arm’s-length transaction” is that some appraisers tend to equate ALTs with market value. This school of thought contends that the terms are mutually inclusive and that non-arm’s length transactions don’t take place at market value. This is simply not the case. Suppose an elderly man intended to sell his house and move into assisted living. His daughter wanted to buy the house and in fairness to the other family members, two appraisers were hired to appraise the property at market value. The selling price was based on an average of the two appraisal reports. In this case, the parties are related so the sale would not qualify as an ALT, but if the appraisers were competent, the transaction would be taking place at or near market value.
A seller may choose to “test” the market with a list price above market value to “see what happens.” In an active market, this “test” may be rewarded and the property may sell at, or even above market value. On the other hand, the owners may price the home well under the market to assure it moves quickly even though they will net less than market value. Either way, if the buyer(s) and seller(s) are unrelated and each acting in what they think are their own best interests, the transactions are considered arm’s length even though they may be selling for more or less than market value.
So while a non-arm’s length transaction may be a red flag that can point to an above or below market value transaction, the bottom line is that ALTs may or may not take place at market value.
Another area of misconception among appraisers regarding ALTs involves the application of the term “related parties.” Unfortunately, the term “related parties” is not defined in any authoritative appraisal-related literature that I am aware. The term is, however, defined in accounting standards and by the Internal Revenue Service, most notably in the IRS guidelines for exchanges of like-kind properties.
Based on these sources, “related parties” would include:
- Family members include only siblings (half-blood or whole-blood), spouses, ancestors, and lineal descendants
- An individual and an entity (corporation or partnership) where the individual owns either directly or indirectly more than 50% in value of the entity
- Two entities in which the same individual owns directly or indirectly more than 50% of each
- An estate in which an entity is either the executor or beneficiary of the estate
- A trust in which the entity is the fiduciary and the related party is a beneficiary either of that same trust or a related trust or a fiduciary of a related trust
- An affiliate — a party that, directly or indirectly, through one or more intermediaries, controls, is controlled by, or is under common control with an entity
While you are free to apply the term “related parties” in whatever manner you choose, if you like the idea of having some support for your notions, you may consider restricting your application of the term to the situations in the bullet points above. Understand the concept of “related parties” as it applies to ALTs is driven by two issues. First, does one party have any level of meaningful control over the other? Second, do either of the parties have any interest in the transaction’s consequences on the other party? If the answer to both questions is “no” then by most definitions, the transaction is likely an ALT. This also applies to situations where the tenant is purchasing the property from the owner. Many appraisers feel that this constitutes a “relationship” but there is a difference between a “relationship” and “related parties,” at least within the context of an ALT.
The issue of ALTs does speak to the importance of data verification. Proper data verification will identify non-arm’s length transactions, which may or may not take place under circumstances that align with the common definitions of market value. Consequently, non-arm’s length transactions are considered suspect in terms of their use as comparable sales and are rarely used as such.