Arm’s-Length Transactions, Part 1

Prior to the advent of the UAD from Fannie Mae and Freddie Mac, many residential appraisers gave little thought to the term “arm’s-length transaction.” The UAD, however, requires the appraiser to distinguish between different types of sales and identify the sale as either arm’s-length or non-arm’s-length. The topic of arm’s-length transactions seems to come up almost weekly on appraiser-oriented Facebook groups and various other forums. From the discussions that take place, there appears to be a significant amount of misunderstanding and differing opinions on arm’s-length transactions, so we thought this might be a good topic for a series of blogs.

Note that in this blog series the acronym “ALT” may be used in place the term "arm’s-length transaction."

So what is an ALT?

The Appraisal Institute’s fourth edition of The Dictionary of Real Estate defined an ALT as: "a transaction between unrelated parties under no duress." In the fifth edition of that publication, the definition was replaced with: "a transaction between unrelated parties who are each acting in his or her own best interest."

The removal of the word "duress" from the previous definition of ALT was welcomed by many appraisers because some market participants mistakenly equated the terms "duress" and "distress" (as in distress sale or distressed sale). There is significant distinction between the two.

Sales under duress are very rare and are not ALTs, even under the newer definition quoted above, because, obviously, at least one of the parties is not acting in his or her best interests.

On the other hand, a distressed sale can, in fact, be an ALT. Distressed sales take place frequently. As a subject for debate, consider this: a household member accepts a job in a distant location and the owners feel they “must” sell their house. Some would argue that this is actually duress because the circumstances “compel” them to sell otherwise they would be “threatened” with foreclosure. This argument falls short of being convincing in that it takes “distress” to a higher level than can be rightfully supported with conventional dictionary definitions of the word. [“Anxiety, sorrow, or pain” Synonyms: anguish, heartache, grief, suffering]

In addition to the definition found in the Appraisal Institute’s The Dictionary of Real Estate there are three other definitions or statements of interest to residential appraisers; two from FHA and one from Fannie Mae.

In the glossary to the FHA Single Family Housing Handbook, an ALT is defined as follows:
“An Arm’s Length Transaction refers to a transaction between unrelated parties who are each acting in their own best interest.” However, in the Handbook itself, the definition reads: “An Arm’s Length Transaction refers to a transaction between unrelated parties and meets the requirements of Market Value.” Some appraisers interpret “meets the requirements of Market Value” as meaning the transaction took place at market value while others interpret the phrase as meaning that the transaction was consistent with the definition of market value. The latter interpretation appears much more likely, because if the first interpretation were correct, it would mean that, by definition, any transaction that took place above or below market value would not be an ALT, which would be an illogical premise.

Note also that FHA has a special definition of ALT for Pre-Foreclosure Sales (PFS) that only applies to a very small number of assignments related to PFS.

Fannie Mae does not publish a definition for an ALT but in their Selling Guide, they speak to non-ALT’s, stating that “Non-arm’s length transactions are purchase transactions in which there is a relationship or business affiliation between the seller and the buyer of the property.”

Let’s look at the differences between the definitions.

• The Appraisal Institute definition and the FHA glossary definition are essentially the same.
• The FHA Handbook definition is a little different, in that it calls for consistency with the definition of market value. FHA’s definition of market value includes “a reasonable time is allowed for exposure in the open market” which is not included in either the Appraisal Institute’s definition, the FHA glossary definition or the statement from Fannie Mae.
• The statement regarding non-ram’s-length transactions from Fannie Mae includes a reference to a “business affiliation” in addition to a relationship between buyer and seller.

In subsequent blogs on this topic, we’ll go into some detail as to what is meant by “related parties” and “business affiliation” and attempt to provide you with the tools you need to determine if a transaction is arm’s-length or not.