Why No One Wants to Lend on Your Sober Living Rental

I am a licensed mortgage originator (NMLS 804170). I am not an attorney or any sort of legal expert. The following is based on my research and my understanding of it. Please always consult your own qualified professionals before making decisions.

While I regularly receive inquiries from housing providers who want to refinance their Single Room Occupancy (SRO) property, it is very difficult to find lenders who will allow this type of income structure. I can generally find a way to get it done when the tenants are students and the property is near a university, but lenders get very leery of anything that might be deemed a "boarding house." Now I finally know why.

Listen to a podcast of this article at the bottom

Let’s start with SRO. In the current age of digital nomads, remote workers, and a higher percentage of the population remaining single and childless, rent-by-the-room makes more sense now than ever. Digital nomads can sign a 30, 60, or 90-day lease, after which they are free to begin their next adventure in their next locale. When you combine these factors with mass workforce reductions, stagnant wages, and inflation exceeding 4%, renting just one room with utilities included and no upkeep may be a wise financial decision.

I can certainly see the appeal… though my husband, child, and three dogs prohibit the notion for me personally.

It can make good financial sense for housing providers, too. Today’s interest rates of 6.5% to 7% on DSCR loans, combined with insurance premium increases of as much as 75% in some markets, a 4 bedroom single family home purchase doesn’t cashflow at your standard 12-month lease income levels. Short-term rentals (STR) were offsetting that for a few years, but many STR markets are now over-saturated or highly regulated, sending many former STR providers looking for alternative solutions. Plus, demand has drastically decreased since Covid-19 social distancing restrictions have ended.

I have always said to make sure that the property cashflows based on standard long-term rental rates and this is why!

It’s completely understandable that housing providers would consider SRO to get their properties cashflowing again and to be able to continue to grow their real estate portfolios. That $400,000 4-bedroom house isn’t eligible for much leverage at $2500 in monthly rents for a standard 12-month lease, but it works nicely with $5500 in SRO income!

Somehow though, lenders are not at all on board with this trend and I couldn’t make it make sense. Here is what I’ve found:

Asset Quality (The Unsellable Floor Plan)

There is information being passed around as wisdom that by limiting common areas in these roommate situations, especially roommates who are unknown to one another, disagreements and fights are limited, as well. Fewer fights and disagreements lead to less headache, turnover, and expense for the housing provider. Nearly all of the real estate investors I know are innovative and savvy. Many SRO providers have killed two birds with one stone by converting common areas like living rooms and dining rooms into additional bedrooms and bathrooms. This increases the number of tenants to whom they can lease, increasing their net cashflow, and reducing potential for upset between tenants.

While that may appear very clever at first glance, should the loan go into default and the lender have to foreclose, how easy do you imagine it is to recoup losses by selling a family home with no living room or dining room? Correct: It’s not. In the event that the lender has to foreclose, they are stuck with collateral that is nearly unsellable except to investors, and you all know that we don’t pay top dollar for anything!

Local Regulation (The Super-Priority Threat)

Many local municipalities have passed laws limiting how many unrelated people can live together in one dwelling. The justifications range from preventing noise to protecting infrastructure. There is increasing pushback against these laws, but they do still exist. Violations of local ordinances can cause fines to be levied against the owner of the property – the housing providers – and those fines can become liens if they remain unpaid. Guess what liens take priority over lender liens? That’s right: government liens. They almost always have “super-priority” status. So your lender has a nicely secured first position lien, that winds up junior to super-priority government liens, and lenders don’t like that. At all.

Criminal Activity & Fraud (The Ultimate Dealbreaker)

This is the really big one, especially for group homes, sober living homes, or anything to do with behavioral health or treatment. Many of these programs are paid by Medicare or Medicaid or are heavily government-subsidized.

Unfortunately, there has been a rash of bad actors in this service niche, resulting in substantial prosecution efforts. Fraudulent operators have been caught billing for services, therapy hours, and drug tests for tenants who were no longer present, or who were even deceased. In 2023, there were over 300 such instances in Arizona alone, where the state’s Native American population was heavily targeted as occupants.

When investigations begin, the state or federal government suspends all payments instantly. If, for example, one master lease operator has three properties with each of five housing providers and there is an investigation at a single property, government payments are suspended on all fifteen properties. Because the lucrative income dries up overnight, the operators stop paying rent, which causes the property owners to default on their mortgages. All of this could happen because one house manager of the fifteen properties thought it would be fun to steal a couple grand from Medicaid.

Remember what I said about the government having "super-priority" status? Right – Lenders cannot foreclose on these properties because of their active seizure status in criminal prosecutions. When the federal government files an in rem civil asset forfeiture action against a property under federal statutes (like 18 U.S.C. § 981 for wire or healthcare fraud proceeds), the federal court takes constructive control of the physical real estate.

Under the legal doctrine of Prior Exclusive Jurisdiction, state courts are completely barred from exercising concurrent jurisdiction over that same property. This means a lender cannot proceed with a standard state-level foreclosure or obtain a writ of possession; they are entirely locked out of their own collateral until the federal forfeiture case is fully resolved—a process that often takes years.

To pour salt in the wound, lenders are then forced to shell out untold amounts of money in legal fees just to petition the court to release their collateral.

Now, recall that while there may be dozens or even several hundred DSCR lenders in the US, they virtually all securitize their notes and sell them to the same handful of institutional note buyers and hedge funds. If the loans they create don’t follow strict secondary-market guidelines, those institutions won’t buy them, and the lender is stuck holding a non-liquid, high-risk note on their books.

Ultimately, almost all DSCR lenders underwrite to the exact same sets of conservative guidelines. There is not a whole lot of variation amongst them. Not to mention that even if some of these institutional note investors have not been pinched in these waves of legal action, they definitely know about it. Their very well-funded legal departments are not going to let them take on this sort of risk.

Additional Considerations

Even if a lender manages to bypass the federal government and foreclose on a boarding house, or a landlord evicts the master lessee, they inherit a fragmented, operationally unstable tenancy:

• Licensee vs. Tenant Status: Property managers often mistake boarding house residents for transient "guests." However, in most jurisdictions, if a resident stays longer than 30 or 31 days and pays weekly/monthly, they are legally classified as "tenants" and are entitled to full landlord-tenant protections.

• Multi-Unit Procedural Multiplication: Because each resident has an independent rental agreement with the operator, the lender or property owner cannot file one single eviction. They must file separate unlawful detainer actions against every individual resident, multiplying filing fees, process server costs, and legal representation.

• Protecting Tenants at Foreclosure Act (PTFA): Under federal law, a successor in interest after a foreclosure must honor bona fide leases or provide a minimum 90-day written notice to vacate. In informal room-by-room boarding situations, proving who is a "bona fide" tenant at market-rate rent is likely to become a long, drawn-out court battle.

• The "Net Equity" Trap in Federal Forfeiture: Private lenders need to know that even if they successfully assert the statutory Innocent Owner Defense under 18 U.S.C. § 983(d), they do not get a full recovery. Under federal asset forfeiture rules (specifically 39 CFR § 233.9(b)(10) and 28 CFR § 9.2(k)), a lienholder’s protectable "net equity" is strictly calculated as the unpaid principal and interest up to the date of the property’s seizure. You cannot recover post-seizure interest, default interest, or attorney’s fees through the government’s administrative petition process. Fighting the Department of Justice to release your collateral requires hiring specialized federal defense counsel, which can easily cost tens of thousands of dollars and bleed a private lender's reserves dry.

• The Appraisal Mismatch: Standard DSCR platforms require residential appraisals using the sales comparison approach. Private lenders should never underwrite an SRO or boarding house based on its business cash flow (e.g., $5,500/month room-by-room revenue). If they advance capital based on that inflated operational income, they are underwriting a business rather than real estate. In a foreclosure, they will be left with a property whose intrinsic residential value is far lower than the debt.

WARNING TO YOU AS THE PROPERTY OWNER

Even if you are not operating the facility yourself – for example, if you have a master lease with a non-profit organization that runs the sober living home – you are in the exact same danger zone as the lenders.

Under 42 CFR § 455.23, state Medicaid agencies are legally mandated to suspend all payments to a provider upon determining a "Credible Allegation of Fraud" (CAF). It can be triggered by simple billing anomalies identified through claims data mining, hotline tips, or routine audits. Once it’s verified by the state’s preliminary audit, payments are frozen instantly, and the case is referred to the state's Medicaid Fraud Control Unit (MFCU) or federal law enforcement.

Don't assume a master lease protects you. In the wake of the $2 billion Medicaid fraud scandal, Arizona passed a strict sober living oversight law in April 2025. It mandates annual inspections and unleashes fines of up to $1,000 per day for violations. When those fines go unpaid by a fraudulent operator, they become super-priority government liens that take first position automatically.

But Wait, There’s More

Remember that if the properties become part of the investigation or criminal prosecution, you don’t have access to them either. You can’t just terminate the lease, evict your master tenant due to non-payment, and move on with your housing provider activities.

In 2024, the Supreme Court ruled in Culley v. Marshall that lienholders and property owners are not constitutionally entitled to a separate, speedy preliminary hearing to seek the immediate, temporary return of their seized property. If a private lender’s collateral is seized under a federal civil forfeiture warrant, they must wait for the main trial to conclude before they can recover their asset. The property will sit vacant and deteriorating for months or years, generating zero cash flow.

It’s no surprise to me that the loans generally go into foreclosure in these situations – only the big institutions have the capacity to fund the legal battles to get the properties released. The average mom-and-pop real estate investor can’t fund that sort of fight; especially if the same master tenant had a number of their properties rented. Your risk is exorbitant.

What Now?

As a real estate investor, with this knowledge, I will not be considering any tenants of this nature, no matter how lucrative. As a licensed mortgage originator, I won’t be seeking funding for these properties any longer. And as a private lender, you couldn’t pay me enough to make it worth my while.

Let me be clear: if you are renting a three bedroom home to three college students near a university, or something similar, I got you. We can get a DSCR loan for that. But if you are running or master-leasing homes for vulnerable, government subsidized populations such as sober living or behavioral health, or if you are lending on these, I cannot recommend strongly enough to take a good hard look at your overall risk.

And look, if that’s you, don’t beat yourself up about it. You probably didn’t know.

When we know better, we do better. Take a few deep breaths, make a decision you can be comfortable with, and take the necessary steps, if applicable. Let me know if I can help. I am always cheering for you.

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This is not a commitment to lend. All applications are subject to credit and underwriting approval. Programs, rates, terms, and conditions are subject to change without notice.

Barrett Financial Group LLC, NMLS 181106
2701 East Insight Way, Suite 150
Chandler, AZ 85286
Kristin Fleming NMLS 804170

Licensing Information: https://www.barrettfinancial.com/licensingorhttp://nmlsconsumeraccess.org/