The duplex cash flows on paper. Unit one is leased to a stranger at 1,450 dollars. Unit two is leased to your sister at 900 dollars, because she helps with the yard and you would rather have family in the building than a tenant you have to screen.
You submit the file with 2,350 dollars of gross rent. Underwriting comes back using 1,450 plus an appraiser’s opinion of market rent for unit two, and the number it lands on is not 900 and not always what you expected either.
That substitution is the whole subject of this post. A lease between you and someone related to you is not treated as evidence of what the unit rents for. Here is what replaces it, why, and what the ratio does when it happens.
Why a lender discounts the lease
A lease is used in underwriting for one reason: it is an arm’s length agreement between two parties with opposing interests, so the number in it is decent evidence of market value. The tenant wanted to pay less. You wanted to charge more. The number is where you met.
When the tenant is your sister, your son, your business partner, or an entity you control, that tension is gone. The rent can be anything. It can be low because you are helping someone out. It can be high because you need the ratio to clear. Neither direction is fraud by itself, and both make the document useless as evidence.
This is the same logic lenders apply on the purchase side when the buyer and seller are related, which we cover in buying from a family member, non arms length rules and gift of equity. Same principle, different document.
Who counts as related
There is no single list, and programs differ, but the categories are consistent.
Family. Spouse, parent, child, sibling, grandparent, grandchild, and in most programs in laws and step relations. Cousins and more distant relatives are frequently fine.
Yourself. A lease from your LLC to you personally, or to another entity you own, is a related party lease. So is a lease to a business you operate out of the building.
Business relationships. Your partner in the deal, a member of the borrowing entity, an employee of your management company. A lease to someone with an ownership interest in the property is the clearest case.
The seller. Not related to you, but not arm’s length either, because the seller controls both sides of a lease signed shortly before a sale. A fresh lease signed thirty days before closing gets scrutiny regardless of who the tenant is, which is part of the same family of problems as rent concessions on the lease you just signed.
What replaces the lease
In almost every case, the appraiser’s market rent opinion. On a single family rental that is Form 1007, and on a two to four unit it rides along with the small residential income property report. How that number gets built is covered in how Form 1007 sets the number your ratio runs on, and the mechanics of the rent schedule itself are in the DSCR rent schedule and the 1007 appraisal.
Most programs then apply the lesser of the lease and market rent on an arm’s length unit, and market rent alone on a related party unit. The second part is the one investors miss. If your sister pays 900 and market is 1,250, you do not get penalized down to 900. You usually get 1,250, because the lease is being disregarded rather than used against you.
That cuts the other way too. If your sister pays 1,500 and market is 1,250, you get 1,250. The lease does not carry you up.
Some programs go further and haircut a related party unit, counting seventy five percent of market or excluding the unit’s income entirely until an arm’s length lease replaces it. That is program specific and it is a question worth asking before you build the deal around the income.
Running the numbers both ways
Take the duplex. Purchase at 280,000 dollars, 70 percent loan to value, so a 196,000 dollar loan at 7.5 percent on a thirty year amortizing structure. Principal and interest run about 1,371 dollars a month. Taxes and insurance add 420 dollars. The full payment is roughly 1,791 dollars.
Using the leases as written: 1,450 plus 900 is 2,350 dollars. Coverage is 2,350 divided by 1,791, or 1.31.
Using the lender’s method, with market rent on unit two at 1,250: 1,450 plus 1,250 is 2,700 dollars. Coverage is 2,700 divided by 1,791, or 1.51. The file got stronger, not weaker.
Using a program that haircuts the related unit to 75 percent of market: 1,450 plus 938 is 2,388 dollars. Coverage is 2,388 divided by 1,791, or 1.33.
Using a program that excludes the related unit entirely: 1,450 dollars against 1,791. Coverage is 0.81, and the file does not exist at that leverage. You would be looking at a loan small enough to bring coverage back over the floor, which on these numbers means roughly 125,000 dollars of financing and about 155,000 dollars of cash.
That spread, from 1.51 to 0.81 on identical real estate, is why this question gets asked in the first conversation rather than the week before closing. Run your own version in the DSCR deal calculator, and if the arithmetic itself is new, start with how to calculate DSCR.
Disclose it, in writing, early
The instinct is to say nothing, because the relationship is not on the lease and nobody asks directly. Resist it.
Lenders find these. The occupant’s name appears in more places in your file than most investors realize, which is the point of the four places the occupant actually shows up in the file. A shared last name, a shared prior address, a tenant whose bank transfers come from an account with your name on it, an estoppel certificate that reads oddly. The identity and background screening a lender runs is described in what a pending lawsuit actually does to the file, and it is more thorough than people expect.
An undisclosed related party lease discovered in underwriting costs you the file and sometimes the lender. Disclosed up front, it is an ordinary underwriting condition with a known answer. The difference is whether the discovery is yours or theirs.
Papering it properly
Write a real lease. Same form you would use for a stranger. Term, rent, deposit, responsibilities, signatures, dates. A handshake with a relative is the worst version of this, because there is no document to disregard and nothing to hand the appraiser. If there is no written lease at all, the file goes down the path described in buying a rental with a month to month tenant.
Charge market rent if you can. If your relative pays market, the related party question becomes a disclosure item rather than an income problem, and the underwriting friction mostly disappears.
Collect by transfer, not cash. A rent that moves bank to bank on the first of the month creates the record that supports every later refinance. Rent paid in cash is a known hard case, covered in proving rental income a lender cannot find in a bank statement.
Get the estoppel signed. If you are buying a property where the seller’s tenant is the seller’s relative, the estoppel certificate is where that surfaces. What it asks and why is in the tenant estoppel certificate.
Know when it is a different animal entirely. A lease to an operating company that subleases the units, even one you own, is not a residential related party lease. It is a master lease, and it underwrites differently, as laid out in the master lease to an operator.
What happens when the relative moves out
The related party question does not end at closing. It comes back every time you touch the loan.
Suppose your sister moves out in year two and you lease the unit to a stranger at 1,300 dollars. That is now an arm’s length lease, and on a refinance the lender will use the lesser of that lease and market rent. If market is 1,250, you are underwritten at 1,250. If market has moved to 1,400, you are underwritten at 1,300, because the signed lease caps you.
That is the quiet cost of having under rented the unit for two years. You set a rent for family reasons, the unit is now anchored near that number in the eyes of a tenant who will not accept a four hundred dollar increase at renewal, and your refinance is underwritten off the lease you were able to sign rather than the market you could have reached. What a rent increase at renewal is actually worth against the cost of a turnover is its own calculation, and it is worth running before you accept a below market renewal.
The reverse case is the better one. If you charged your relative market rent all along, the transition to an arm’s length tenant changes nothing in your file, and the unit has a documented rent history at a defensible number.
Build the evidence yourself
You do not control the appraiser’s opinion, but you do control what exists in the file alongside it. Three things are worth assembling before you apply.
A rent comparable sheet you prepared. Three to five currently listed or recently leased units of the same size and condition within a reasonable radius, with addresses, rents and dates. You cannot hand this to the appraiser directly in most cases, and the rules about what you may send are covered in who actually orders your rental appraisal. What it is good for is your own conversation with the lender when the 1007 comes back low and you want to ask for a reconsideration.
The payment history, however short. Twelve months of transfers at a consistent amount on a consistent date is persuasive even on a related party unit, because it shows the rent is real money changing hands rather than a number on a page.
A written market rent note in your own file. If you are charging a relative 900 dollars in a 1,250 dollar market, write down why and when you decided that. Two years later, when an underwriter asks whether the 900 was market, the honest answer with a date on it is worth more than a reconstruction.
None of this changes the rule. The lease is still disregarded. What it changes is the quality of the conversation when the appraiser’s number and your expectation do not match, which on a two to four unit property is a conversation you will have more than once.
The short version
A lease to someone related to you is not evidence of market rent, so the appraiser’s opinion replaces it. That is usually neutral and occasionally helpful. The expensive outcome is the program that excludes the unit, and the only way to know which program you are in is to ask before you structure the deal. Disclose the relationship in the first conversation. If you want to know how a specific related party unit will be treated before you write the offer, reach out. Two related reads for the same file: signing before your entity was formed and what actually conveys with the house.
FMC Capital is a Pittsburgh-based mortgage brokerage, NMLS #1840537. We place loans on rentals and flips for investors across Pennsylvania and additional states. Reach us at 412-990-2941. Loan terms, program parameters and pricing vary by lender and by property and are subject to change. Nothing here is legal or tax advice.