Why an “arm’s-length” sale matters in real estate

I knew a guy who was once given an expensive sports car. I was shocked when he told me someone came up to him and handed him keys to a Porsche. Nice stranger, right? A couple of news outlets even covered the story about this stranger’s generosity. Yet here’s the deal. The sports car owner was on the cusp of divorce and his soon-to-be ex would’ve potentially gotten the car anyway, so this was really more about dumping an asset instead of random kindness.

Image-by-Sacramento-Appraisal-Blog-two-five-dollar-bills-in-hand1

Now with that story fresh in mind, let’s consider the concept of an arm’s-length transaction. There wasn’t a buyer in this situation of course, but still there is something important here to note with the concept of “giving away” a property – or in other words selling at a price that really doesn’t reflect the market.

What is an “arm’s-length” sale? “It is a transaction in which the buyers and sellers of a product act independently and have no relationship to each other. The concept of an arm’s-length transaction is to ensure that both parties in the deal are acting in their own self-interest and are not subject to any pressure or duress from the other party” (Ivestopedia). The classic example of a non-arm’s-length transaction is a parent selling to a child. Instead of the seller acting in his best interest with the highest price, the parent offers the child a discount, which means it is a non-arm’s-length transaction.

Why does it matter whether it is an arm’s-length sale or not?

Chris Opher Loan OfficerChris Opfer of Mason-McDuffie Mortgage explains. Arm’s-length transactions are sometimes confusing to understand, and in many cases can cause big problems for loan officers. The whole idea is to make sure that none of the parties involved knew each other prior to the purchase contract being ratified. The thinking is that each party will fight for the best deal possible for themselves. If any of the parties did know each other, then that would be considered a non-arm’s length transaction and can cause issues when it comes to securing a loan. Loan fraud is always on the top of our minds, and it’s important to protect the buyer from being taken advantage of and to keep the property values consistent with the market and not too low or too high. This is exactly why we are never permitted to do a loan on a property for a short sale when a relative is buying from another relative. Non-Arms-Length deals are definitely possible though as I have done several recently. For example, a parent or child may have purchased a house for a family member who lost their home to foreclosure. Now that the family member can qualify for a loan again after three or four years, the displaced person can buy the house from the relative that bought it for them in the first place. Each transaction is different and should be looked at individually and given much thought before loan application is submitted.

Case-in-Point: FHA allows a family member to purchase another family member’s home as a principal residence if the property is the seller’s investment property. The max LTV is 85% unless the family member has been a tenant in the property for at least 6 months, and then it would be the normal 3.5%. Don’t forget that you have to prove that you were really paying the rent. This is just one example. There is not enough time to go through all of the possible scenarios.

arms-length-sale definition by sacramento real estate appraiser blog

One last “short” example: Lastly, we all know short sales tend to sell at a discount. However, there are some out there that are definitely not arm’s-length sales because they are seemingly being priced strategically low for the sake of a future flip. The game plan goes like this: Agent 1 “lists” the property at a ridiculously low price. The listing is likely only a technicality to show the bank the property was actually on MLS. Then Agent 2 shows up as the Buyer’s Agent on the deal. The property goes pending after zero days of market exposure on MLS. After escrow closes, the property is spruced up moderately, and either Agent 1 or Agent 2 lists the property again. Now I’m not saying this is fraud because it’s not my place to make that call. All I’m saying is this is not an arm’s-length transaction since the buyer and seller are not trying to get the best deal possible for their side, but are instead focused on the future flip transaction.

Question: Any thoughts, insight or stories to share? I’d love to hear your take.

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Comments

  1. ricardo says

    Hey Ryan:

    At the intersection of Del Paso Boulevard and Arden in North Sacramento there is a 60 foot mural — yellow script with blue shading. It says: “In scarcity we bare the teeth.” If you stop to investigate, you will find a poem. Is it about human nature? Our current real estate market? What do you think?

    Ricardo

    • says

      I hear you on that, Brad. It’s definitely a nice set-up for the kids too (assuming parents sell at a discount). I appraised one recently that was purchased several years ago by the parents, and the kids had a good 10%+ equity in the house once they purchased it (FHA loan).

        • says

          Great question, Brad. One might think that would be the case, but I think of the following. First, the sale would probably be private, which means it is not on MLS. The sales on MLS are probably going to be what really sways the market the most. Appraisers don’t usually use private sales as comps unless they can be verified by a party to the transaction. Of course there would have to be a compelling reason to use private sales anyway if there are ample MLS sales to choose from. Secondly, one sale doesn’t make or break the market. Even if the sale was on MLS, it would be easy to give little weight to the sale if it sold at a discount. That is what I tend to do with short sales when they closed at insanely low levels (like the ones I mentioned at the end of this post).

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