The last few podcast episodes have explored alternate real estate investing strategies like large-scale multifamily and fix & flipping.
But two more strategies worth deep-diving on are: private lending (i.e. hard money lending) + foreclosure auction investing/flipping.
So this week, I invited former BigLaw attorney turned real estate investor Ethan Gao to share about his experience as a hard money lender and foreclosure auction flipper.
Ethan has made over 120 hard money loans and flipped over 100 foreclosure auction properties, making serious double-digit returns in the process.
Bigger risk, bigger reward, right?
…Except Ethan would argue, the risk isn’t necessarily bigger. If you know what you’re doing, it’s actually smaller. It just requires more upfront cash.
Tune in to our interview to learn all about:
- Why Ethan pivoted from syndications and crowdfunding to hard money lending and foreclosure auction flipping
- How he finds and vets hard money borrowers, how much he typically lends, on what terms, and what happens when a hard money loan goes bad
- How foreclosure auctions work step by step (including bidding strategies, and why you need to bring tons of cash on top of cashier’s checks)
- How to get the list of auction properties in advance and how to diligence them before auction day
Have you invested in foreclosure auction properties or loaned hard money before? Did you earn higher returns? What key lessons did you learn? What other questions about lending / auctions do you want answered? Let me know by leaving a comment when you’re done.
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Links mentioned in this episode:
- ethangao at gmail dot com
- Foreclose Houston
- HYW private Facebook community
Read this episode as a post:
My guest today is Ethan Gao.
He is a Houston-based real estate investor who focuses on hard money lending and fix-and-flip rehabbing for single-family homes. He’s made over 120 hard money loans over the past four years, and has flipped over 100 houses in the last three years.
He’s an alum of Cornell and Columbia Law School, and before becoming a real estate investor, was a corporate attorney in “Big Law.” He’s currently also a financial advisor for high income professionals, business owners, and real estate investors.
Ethan, thanks so much for joining us today to share insights and tips about hard money lending, house flipping, and other alternative real estate investing strategies.
Ethan Gao 01:55
Thanks so much for having me.
Andrew Chen 01:56
Cool. I’d love to start just by learning a little bit more about your background.
We spoke before. I know you do two different types of real estate investing: hard money lending and fix-and-flip rehabbing.
Hard money lending being loaning money as a private lender to other real estate investors and fix-and-flippers. And fix-and-flip rehabbing is buying and improving a property yourself.
But I know from our previous discussions that you started with investing in syndications, some crowdfunding websites, and you later pivoted to what you’re doing now. Can you walk us through how your evolution occurred and how you got into real estate investing?
Ethan Gao 2:32
Sure. It really happened in a couple of stages.
The first stage is getting into real estate investing directly. So I bought a rental property. I never thought I’d be a real estate investor.
I had a Wall Street background. My wife has the same Wall Street background. So we had always just invested in stocks and mostly just index funds.
We bought our first rental property about four or five years ago, and then we dealt with the typical tenants and toilets and various hassles of not being experts on how to fix anything or how to manage anything, as well as myself having a very busy job and my wife having three, now four, children. It was extremely hard to manage, and the returns were not good.
I was watching TV late at night, saw some infomercials, and Googled around, trying to figure out how in the world people made money in real estate investing, because you see all these TV commercials and internet ads about “Hey, I barely graduated from high school. I made $50 million flipping houses or doing whatever, and I didn’t have any money.”
And I’m looking at myself, saying, “Well, hey, I got a premium education. I got a professional job.”
“I got tons of money. How in the world am I not making any money in real estate?”
I have to own 100 of these rentals to make any money. And I don’t have $20 million laying around.
So I started doing deep dive due diligence.
Bigger Pockets was a really helpful website. Reading people’s stories and articles about how to do it. Various internet things.
And then the second evolution was getting comfortable investing in real estate as an asset class and then investing a bunch of syndications. That coincided with the JOBS Act, where essentially securities raising for smaller stuff was just much easier. So a lot of websites came to the fore, essentially allowing accredited investors to put $5000, $10,000 in the projects.
There was a period of time where I invested in almost every opportunity that popped up on a few of those websites, using the investment thesis that I don’t want to do anything locally because my job is too tied to the local economy.
And in particular, Houston is an oil and gas town, and most of the stuff we did was oil and gas-related. So essentially, I felt like if I invested too much in Houston, then I’m doubling or tripling down on oil and gas. That’s why I invested in all of these out-of-state syndications and the like.
And a little bit through that, nothing really particularly bad happened in the first six months to one year because poor results rarely happens that early. It’s later on, second and third year when the issues show up.
So along the way, I pivoted again and I just thought, “Well, hey, I’m a really smart person. All we really do is do due diligence on things and figure stuff out for clients, etc.”
“Why isn’t it that I couldn’t add alpha by doing stuff in town where, number one, I know the area, and, number two, I can actually meet people in person and figure out what they’re doing?”
So that was the second stage of my real estate investing career where I decided to go to a lot of local real estate networking events and figure out who the players were and figure out who would be good to do business with.
And I guess I probably lucked out in this regard because a lot of investors will tell you the first deal they did, they lost a lot of money where they invested with the wrong person. And the first guy I invested with, it’s probably one of the best deals that I’ve ever done.
Essentially, I lent a guy money to flip a house. And he explained it all to me. He wasn’t quite new, but he was starting to do it professionally.
He had a W-2 job. He had flipped a couple and had a couple of rentals, but he wanted to quit his W-2 job and do this full time. And obviously, he doesn’t have that kind of money to do it all himself, as they rarely do.
So he essentially had a deal where he was buying it for x. And he actually already had it sold for x times 1.1. He was just making the spread in between, almost like a wholesaler would, but the timing just didn’t line up for him.
He basically needed a loan for two weeks. So I made out a loan. My effective IRR was extremely high because the short duration of it made the points worth quite a lot in percentage points.
So that was my first deal. Once we did that and I got paid back in two weeks with an extremely high IRR, I got a lot more comfortable doing that type of transaction.
Andrew Chen 6:59
Got it. Awesome. Beautiful.
If I just back up for a moment, you mentioned that when you were investing out of town with the thesis that you wanted to diversify away from oil and gas, which makes total sense, and you went to some of these crowdfunding sites and other syndications, the problems rarely crop up in the first 6-12 months. They rear their head after year two, three, and beyond.
What are some of the notable problems that you saw from your own experience or that you have seen for folks who also have the same rationale for wanting to diversify out of their own hometown?
Ethan Gao 7:35
Really, it’s dovetails with what you and I were discussing before, which is, sponsors in this space, especially the small to medium-sized ones, do not really have the expertise that you would really want them to have, nor do they have the capital or the skin in the game that you would want them to have.
I’m not talking about the big sponsors, like the Blackstones or Carlyles of the world. That’s completely a different animal. I’m talking about the crowdfunded stuff, the mid cap to small cap stuff.
What’s happened in some of the deals I’m in, for instance, there was a deal in Memphis, Tennessee on an apartment complex that paid a relatively high interest rate. It was supposed to pay off within a year, and it’s gone on for three years. So it’s two years overdue.
The crowdfunding site just said, “Well, we don’t really want to deal with this. The guy is still making interest payments, so why don’t we just keep it?”
Okay, fine. Everybody’s not happy. But if you’re making a 12% annual interest and you’re getting it consistently, you’re not super unhappy, although you might not be happy.
Long story short, it was then discovered that the operator had tax liens on it. The operator then kept on representing and working to the crowdfunded website that it was under contract to be sold. And then it would produce an extremely poor contract that looked like it was faked, and then the closing would never happen.
So essentially just the typical “check’s in the mail…oh no really, check’s in the mail” type of excuses. And right now it’s going through foreclosure.
That’s probably going to be one of the better outcomes because we had collected three years of interest payments at 12% that even if we lose a significant amount of principal, we may actually come out ahead.
It wasn’t worth the effort or the time or the risk. Risk adjusted, it was a terrible deal. But you didn’t necessarily know that upfront.
And that was a 40% LTV deal. That would mean you lent $400,000 against an asset worth $1 million.
Theoretically, you can’t lose money in a foreclosure, but I’ll bet you we will. I will bet you 100% that we will lose some amount of principal.
And that’s not even the worst example. There’s others where there’s fraud. Somebody just took the money, did not use it for the use of proceeds, made two interest payments, three interest payments, and has skipped town.
And then one guy actually went to jail. He had been embezzling and defrauding a bunch of investors. We were a pretty small fish, and then the crowdfunding website decided, “It’s really not worth our effort to continue to chase him legally.”
“The personal guarantee is worthless. He’s already in jail. Let’s not even bother.”
So that was a total loss.
It’s not a high percentage, but I have a pretty large sample size because I had invested in such a large number of these deals over a relatively short span of time early on in crowdfunding when due diligence was probably worse and quality assurance was worse.
Let me just back up and say, one can easily lose one’s money in things like this.
Andrew Chen 11:06
Have the underwriting standards improved since then, or it’s still caveat emptor (buyer beware)?
Ethan Gao 11:14
I would assume they would have to have improved just by virtue of time. People must have learned something from the early days, one would hope.
But once I started facing issues and once I had success doing it locally, the risk-reward analysis and the local alpha completely outweighed me investing in any sort of crowdfunded or any sort of investment fund. So I haven’t kept in touch.
Andrew Chen 11:41
Got it. Makes sense. You mentioned that you invested in many deals, large sample size over a fairly short period of time.
I realize maybe some of the deals are still in flight, but based on what you know now, at this point, what proportion of the deals would you say are going to come out better than you even expected, about what you expected, versus totally not what you expected or just not what you expected?
Ethan Gao 12:09
Let’s focus on the bad because those are the ones you remember easier. I would say about 20% of what I invested in was sub pro forma and suboptimal, with a relatively large number of severe principal loss or total loss.
That’s one of the reasons I like investing locally, because the drawdown risk is much lower. If I invest in a local house in Houston, I’ve got a pretty good sense of the value regardless of how much fix-up I have to do or how long I have to keep it on the market.
And worst case, if I ever had to, I could always just make it into a rental property and not even necessarily take a mark to market loss. Whereas in a syndication or in a fraud situation, you’re just looking at total losses regardless of what’s going on.
Andrew Chen 13:04
Got it. Say 20% are bad. What percent exceeded expectations or may exceed expectations?
Ethan Gao 13:13
I think I had two or three that clearly in my memory exceeded the pro formas. That will be out of over 100, so we’re looking at less than 5%.
Andrew Chen 13:25
Ethan Gao 13:28
And again, the negatives severely outweigh the positives. That’s the problem. The negative surprises massively envelop the positive surprises.
It’s extremely rare that someone is going to give you 4x what they thought pro forma. Whereas in a fraud or whatever, you can lose 100% of your money. So it’s totally asymmetric.
Andrew Chen 13:51
The founders of these crowdfunding sites or even the sponsors in these syndications, their reputation is presumably at risk. Maybe that’s not fraud if they lose your money, but they’re not going to do business again.
Ethan Gao 14:08
Au contraire, mon frere.
Andrew Chen 14:10
How do you mean?
Ethan Gao 14:13
Well, I can tell you locally, for instance, there are guys with multiple bankruptcies and multiple lawsuits that I know of here, that I’ve met in person, still running around town doing deals.
Maybe on the bigger platforms where there’s any sort of due diligence, perhaps it’s harder. But real estate tends to attract some pretty unsavory characters and a lot of repeat customers.
Andrew Chen 14:40
How does their reputation not prevent them? Because word will get around from raising more money or finding other limited partners and investors.
Ethan Gao 14:52
Market inefficiency. Lack of due diligence. I see it all the time, at least locally.
Andrew Chen 15:03
So you pivoted locally because it sounds like you came to the realization, “Hey, I am in a line of work where I’m doing due diligence all day anyway. Maybe I can do it better than the sponsors who don’t seem to be doing a very good job in the first place.”
And it sounds like you were going to meet-ups and starting to build a network locally and meeting folks. What kind of borrowers are you lending money to as a hard money lender?
Ethan Gao 15:32
Unlike other guys that are in this business, I focus on both the operator as a human being and a businessperson, as well as looking at the specific asset.
Many hard money lenders, they just tell you, “I don’t care what your credit score is. I don’t care if you’ve been through multiple lawsuits, bankruptcies.”
“All I really care about is I foreclose on your property because you didn’t pay me or if you got hit by a bus, so I have to take it back and fix it myself.”
“Am I going to lose money or am I going to make money?” That’s essentially their underwriting.
I don’t quite take that view.
That’s important. That has to exist. But the operator also has to be good because, especially as lawyers, we know if a borrower declares bankruptcy, they can do all kinds of dragging out the processes in terms of foreclosure.
If somebody is super intent on defrauding you in some way, it doesn’t quite matter what your legal documents say. If they’re truly motivated to do it, they’ll end up doing it in some manner. It’s just a matter of small versus large and quick versus drawn out.
So I like lending to guys that have a squeaky clean record, no bankruptcies, no lawsuits. They don’t have to have credit like mine, but I don’t want them to have a credit score where they actually have to try to get the 550s of the world, where you have to purposely be more or less a deadbeat to get that. No offense to people with 550 credit scores.
Andrew Chen 17:11
How are you diligencing this? Are you looking at court records to see if they’ve been in court?
Ethan Gao 17:18
It’s actually quite easy. There’s several relatively cheap programs where you can skip trace people. It’s not quite as intensive as a background check.
And actually, there’s been a couple people who I’ve thought about getting background checks on or have done more due diligence on.
But there’s skip tracing software that you can type in a person’s name, approximate age, etc., and it gives a pretty good comprehensive record. Some people’s speeding tickets will show up. That’s the relatively picayune level of things.
Andrew Chen 17:56
Got it. So when you’re evaluating the operator, is it fair to say that you’re looking at basically things that are red flags, reasons why you shouldn’t lend more so than their actual successful track record?
Because as you mentioned, as long as the property seems like you can be able to recover your principal even if the operator doesn’t do a good job or whatever, then all that matters is that they’re not a bad actor.
Ethan Gao 18:25
Those are the knockout factors. Those red flags are enough that it doesn’t matter how good the property is.
If they’ve been through multiple bankruptcies or they don’t know what they’re doing or they’re in all kinds of shady, fraudulent stuff, just don’t do the business. It doesn’t matter if they’re going to give you 100% return or 1% loan to value. Just run as far as you can the other way.
Now, in terms of affirmatively wanting to do business with someone, people with a track record are a lot more attractive because, especially if they live through at least one recession or one real estate downturn cycle, that means they’re just more qualified to deal with the stuff that happens during that.
Some of which won’t even be their fault. Some of which is market base.
But the fact that they’ve been through it, basically it’s survivorship bias. If they’ve survived one, they’re more likely to survive the next.
And then one other caveat, I would say, is there’s a subset of operators who don’t have the track record, but they’re actually really good to lend to. And they are people with W-2 jobs, good finances, good credit, who are entering into this space and wanting to do this either as a hobby, a semi-business, or an actual business. And the reason for that is because they have the financial wherewithal to weather a storm.
I’ve made quite a lot of money lending to a couple of guys who I gave them my honest opinion. I said, “This deal is not the best in the world, but you’re willing to put so much money down to make my loan to value so low.”
And I know that ultimately, if you are not able to sell it for the price that you want, which they never will, one of the biggest mistakes with first time guys doing this business is they list their property way too high. They think it’s the best thing since sliced bread. And then when you tell them their baby is ugly, they don’t listen and they don’t cut it fast enough and they just hang on.
That actually increases the amount of money I make because I’m holding on to a note where you have to pay my interest regardless. That’s not my ideal situation, but these folks are able to weather the storm and they’re able to refinance you out with conventional financing even if they’re not able to sell the property.
Andrew Chen 20:46
Got it. Cool. Makes sense.
How much are you lending on a typical deal?
Ethan Gao 20:50
I like houses in the $100,000-$250,000 range, but I’ve done as little as $50,000 and as high as almost $1 million. It just depends on the situation. But the middle 80% would be between $100,000 to $250,000.
Andrew Chen 21:06
That’s the home value or the amount you’re lending?
Ethan Gao 21:11
Amount I’m lending. The median house in Houston would be around $200,000 or so.
Andrew Chen 21:17
I see. What are the typical terms that you’re attaching to a loan like that in terms of the interest rate, tenor?
Are you in first position? What is the LTV target? Is it recourse, etc.?
Ethan Gao 21:29
Nerding out legally, tenor is usually 3-12 months. The way I like to do my own loan documentation is a one-year note with an automatic extension at six months upon the payment of a predetermined fee.
Rates vary between 10%-13%. Points vary between 1.5 to 3 points or so.
Now, that shifts quite a lot with the market. In the past two years, my loan portfolio has gone dramatically down because there’s been a lot of institutional Wall Street type of money chasing these types of deals.
And it filters through the ecosystem where folks are just able to borrow, especially good operators are able to borrow substantially cheaper than they’ve had before.
Loan to value, I always target 70 or less. But for repeat guys that I’ve done a lot of business with, I’d be willing to consider up to 80, depending on the situation, although that’s not preferred at all. The situation has to make sense.
I only do first position. I have done second lien position in crowdfunding, one of which was a total loss and one of which was a 70% loss. Second lien, depending on the situation, you might as well be equity.
Andrew Chen 22:56
Got it. And are these loans recourse?
Ethan Gao 22:58
Yeah. I always get a personal guarantee.
Not all hard money lenders require that because they take the practical view, which if you’ve done any sort of bankruptcy work for a big company, the guarantee is worthless. You’re in bankruptcy court. Who cares?
And then for some of these small potatoes guys, what does it matter that you can ruin their credit? So what?
Andrew Chen 23:20
Yeah. So what is worth it to you, then, in light of that?
Ethan Gao 23:25
It’s really the attitude about the whole thing. Someone who’s extremely dead set against a personal guarantee strikes me as either too sophisticated or just sophisticated, which has its good and its bad.
And then the other aspect of that is if they refuse to give a personal guarantee, then I’m not really confident that they’re confident in their own ability to do the business. Therefore, why should I be confident in backing them financially?
Andrew Chen 23:55
Yeah. Cool. Makes sense.
When you find potential borrowers, how does the conversation unfold?
You go to meet-ups or you’re networking, and you meet somebody, a potential borrower. It’s like, “Hey, I’m Ethan. What’s your name?”
What are the things that happen in the middle to get you to “Here’s a hard money check for $100,000 or $150,000”?
Ethan Gao 24:24
First thing, if you go to a meet-up and you tell people you have money, whether as a lender or as an investor, you don’t need to worry about people coming up to talk to you because you will attract them like moths to a flame, because there’s plenty of people that either want to rip you off or want to borrow your money or whatever.
Essentially, you have the conversation, and then you just have a very normal flow conversation. You ask them about their background.
You ask them about their track record. You ask them about what specific deals they have now. You ask about what they’re looking for.
If they’re sophisticated and they’re a repeat operator, you just ask them, “Hey, what are your other lenders giving you?” Because you can just negotiate on the spot there and just see if there’s going to be a fit.
If they’re borrowing at zero points and 8%, similar to a bank loan, I’m not interested in that. If they’re borrowing at some outrageous rate, then you probably know they’re either very unsophisticated or they’re really dumb.
And you really have to do enough due diligence to make sure you’re comfortable with a person like that.
Andrew Chen 25:33
I’m just curious. You’re an attorney. The operator or the borrower, my guess is probably mostly they’re not attorneys.
Is counsel involved? Are they hiring attorneys or are they basically unrepresented?
Ethan Gao 25:49
No, they’re almost always unrepresented. Very rarely are they represented.
Well, it’s a combination of three things.
Number one, they don’t have the level of sophistication to even worry.
Number two, they’re cheap.
Real estate investors are very cheap. I think that’s probably true across real estate investors across the world, including myself. They don’t want to spend extra money.
And then number three, real estate documentation and, in particular, loan documentation is extremely standard. It’s really one of those situations that you’re looking at the rates, the points, the fees, and any gotchas that there’s not too much deviation.
So it’s the value add on having two opposing counsel go at it is reasonably poor. A little bit different than Kirkland & Ellis trying to get the best sponsor precedents into one document for a big PE firm or something like that.
Andrew Chen 26:42
Got it. Cool. Have you ever had to foreclose on a hard money loan?
Ethan Gao 26:47
I have gone through one foreclosure. This was a situation where a relatively large operator who a lot of people have lent private money to basically failed in a normal economy and environment. So they get a scarlet letter.
If you fail in 2008 when everybody else is failing, you get a pass. If you fail when no one else is failing, then you really effed something up pretty bad.
And he did. He grew way too fast, took on way too much staff.
My particular deal had no issues. He did it slower than expected, but still on time. He made all his payments, except for the last payment.
And then he basically had to call every single one of his lenders, and I was last on his list. I heard from other lenders that he was making these calls, so I knew about it before he even called me.
And he said, “Hey, look, I’ve already hired bankruptcy counsel. I’m investigating declaring Chapter 11 bankruptcy.”
And I’ve lived through that professionally before, and it’s no good for anybody. And he didn’t make the last interest payment.
So I told him, “Look, I’ll work with you as best as I can, but I’ve got to just initiate the process.”
Because if you miss it, and you’re in the Chapter 11 framework, and now you’ve got to make all these filings with the judge and wait, that’s way worse. You don’t want to subject yourself to that.
So I went through the foreclosure right away. And he even told me he actually sold the property. It was at the title company waiting to be sold.
But again, here in Texas, foreclosure is the first Tuesday of every month. So if you miss that, if you miss the filing 21 days prior notice, you’re looking at the next month. And in that time, he could have easily been under Chapter 11.
So I did the entire paperwork. And basically two days before the foreclosure auction, I got a wire from this title company paying the entire amount of the principal and the default interest and the legal fees I incurred to do the paperwork to do the foreclosure.
Andrew Chen 28:55
Did you hire attorneys to do the paperwork, or did you already know how to do that yourself?
Ethan Gao 29:00
I knew how to do it, but I hired an attorney anyways, just so in case there was a lawsuit, it’s a better position to be in.
Andrew Chen 29:10
I see. Interesting.
Ethan Gao 29:14
And I’ve done that paperwork for other lenders.
Andrew Chen 29:18
Real estate investors?
Ethan Gao 29:19
Andrew Chen 29:20
Ethan Gao 29:21
I just don’t do it for myself. If you do it for yourself, if you’re in front of a judge or there’s a lawsuit, you’re just opening yourself up to a little bit more risk than what I’d prefer.
Andrew Chen 29:31
How is that?
Ethan Gao 29:33
I just think any little thing that’s not “standard” could potentially trip you up.
Maybe the judge would say, “Hey, Ethan, you ran up your legal fees here. This isn’t the market. Why did you charge them for the foreclosure paperwork?” Even though it is market. You just don’t really need to make that extra couple of hundred bucks.
That risk-reward trade is horrible. Let’s just end it that way. You don’t need to do it.
Andrew Chen 30:07
For folks who have not been through the foreclosure process as the person who’s doing the foreclosing, at least at a high level, could you describe what that entails? How long should folks expect for that process to play out?
Ethan Gao 30:24
In Texas, most of our stuff is deed of trust. Essentially, especially on an investor loan that doesn’t have any Dodd-Frank or Reg Z regulations, etc., what you’re looking at is you give 21 days advance notice of a posting of foreclosure.
So you send a demand letter, a notice of acceleration, and then you send the notice of foreclosure 21 days before the actual foreclosure, which is the first Tuesday of every month, unless there’s a major holiday and then it’s rescheduled shortly thereafter.
You also then usually hire a substitute trustee to conduct the auction. These are folks that you pay a few hundred dollars to, on the day of the auction, read out the legal description of the property and say the starting bid, usually the principal amount plus accrued interest of the loan. And then investors there will bid at the auction to see who wins it.
Andrew Chen 31:24
Gotcha. When we spoke earlier, you mentioned that before you lend, you or your partner always walk the property first.
I’m curious. What are you analyzing or evaluating when you walk a property? And is it any different than if you were buying it to hold yourself?
Ethan Gao 31:42
It’s not too different than analyzing it, except usually as the lender (and this is true as the lender in any industry), you want to be as much of a subject matter expert as you can.
But fundamentally, you’re the financier, so you’re really auditing somebody’s work. You’re not really expecting to do the work yourself.
So if you have a good enough handle to look at a rehab budget and to walk through a property and say, “It looks like the roof is bad” or “Look at all these cracks. Clearly, the foundation is messed up,” and just have a ballpark or range of costs and time, then it’s usually good enough.
Andrew Chen 32:25
Gotcha. Cool. I want to get to the fix-and-flipping stuff because that’s super interesting as well, but one more question on hard money lending.
The operators that you lend to, I’m sure some are better than others. And the good ones, do they eventually graduate and they don’t need your money anymore, or do they still keep coming back even if they’ve made a lot of money and they’re building wealth themselves and they could potentially finance it themselves?
Are they still explicitly wanting to rehab with other people’s money because it juices their equity returns?
Ethan Gao 33:01
The answer is yes to all of what you said.
There’s a subset of people that once they get bankable or they get more prominent and they have more track record, they’ll just shop the lowest bid and they’ll immediately, or very shortly thereafter, find a cheaper lender, somebody less sophisticated than me or somebody with excess liquidity or just a lower hurdle rate to beat.
My hurdle rate, if I can’t make about 14-15% IRR, I’m not really interested. I’ve got other stuff I can invest in that the risk-reward is more favorable or where I just don’t think it’s worth getting out of bed to take any risk to do a project.
There’s a subset of folks who will never become bankable regardless of how much money they make.
Some of that is a spending problem. They just make a bunch of money and then they spend it all.
And then there’s the tax problem, which is, some people make a lot of money, they refuse to ever pay income tax, and so they never become bankable by a bank.
Andrew Chen 34:05
I didn’t realize this is a thing to not pay income tax even though you’re making a lot of money. Who are they?
Ethan Gao 34:17
There are a lot of people. Google “tax liens.” A lot of people don’t pay their taxes, real estate investors or otherwise.
Andrew Chen 34:26
Ethan Gao 34:27
Underreporting, no reporting, massive overinflation of expenses, whatever the fact may be.
Andrew Chen 34:36
So, shifting over to the fix-and-flip side of your business, I understand this is actually quite a substantial part of how you also invest in real estate. Can you talk a little bit about where your deal flow for fix-and-flips come from?
Ethan Gao 34:55
Sure. The story behind the fix-and-flips is I myself run the hard money lending portion. I’ve been doing that for about a year.
And then within that timeframe in my network, I met an engineer who ended up becoming one of my borrowers. He introduced me to one of his friends who was also a lawyer, who had been flipping houses by himself with his own money one to two at a time.
And what he did was he found them at the bank foreclosure auction. So he would focus on 20 or 30 opportunities every month.
He would drive by them. He would do extensive due diligence. And then he would gather all of his pennies and then show up to the foreclosure auction and bid and hopefully win them.
He didn’t like practicing law that much. He was a litigation guy in small firm litigation, not biglaw.
And his job, honestly, wasn’t that bad. If he didn’t like that, he would have hated biglaw litigation. Biglaw in general, actually, he would have hated all of that.
So he wanted to team up with somebody who had much more money than him to help make that a full time business for him where he could replace his salary as a lawyer. So that’s how I ended up doing it.
And at that point, I had already seen so many of the guys that lent money to make even more money than what I made. So I knew that in the actual flipping and operating of the house, there was more money to potentially be made.
Andrew Chen 36:27
Got it. Where does the deal flow come from these days?
Ethan Gao 36:30
95% of what we bought in those 100 flips have come from the bank foreclosure auction because that’s what his expertise was.
The process for that is about three weeks before the auction, you can subscribe to a list that you pay a few bucks for, and it shows you all the indicative opportunities that will be auctioned off. We pick certain ZIP codes and certain price points that we’re interested in, and then we have a few guys that we pay.
We don’t pay my partner, but he also drives to the houses themselves. They’re taking notes on the condition of the house, how much they expect the rehab to be, what they think the neighborhood looks like.
And then we put together a spreadsheet of what our max bid is on these, and then we go to the auction and we bid on them.
Andrew Chen 37:27
Gotcha. Who publishes the list? Is this the bank, the courthouse?
Ethan Gao 37:32
No, there’s a service called Foreclose Houston that does lists here in Houston. I think all they do is they aggregate the data and put it into a more user-friendly format because I think the information is publicly available.
And the interesting thing about this is Houston is huge. Harris County is where we go, which is the main county for Houston, the city and the immediate suburbs. There will be 1000-1200 houses on the list, but then by the time you get to the auction, half are no longer available.
They’re not being auctioned off because who knows what happens? Somebody asked their mom for a loan and paid off their mortgage or made their mortgage current, so it’s no longer in default.
Some people declare Chapter 11, Chapter 7, Chapter 13, whatever bankruptcy. Then that basically forestalls the foreclosure.
Some people will sue the bank, TRO the bank, and then that will forestall the foreclosure.
Andrew Chen 38:32
Ethan Gao 38:34
Temporary restraining order. They’ll file suit against the bank for unlawful foreclosure or some BS.
They know they’re not going to win in the long term, but if they want a reprieve of a month or two or three. And depending on how much money they’re willing to pay and how shady of a lawyer they get, they can get a few more months of free rent by doing this strategy.
Andrew Chen 38:58
I see. So the list will have easily more than 1000, but by the time you actually get to the auction, only about half.
Ethan Gao 39:07
I don’t keep the statistics on it, but it’s a substantial drop off from the gross number that’s published three weeks before.
Andrew Chen 39:17
What’s the name of the service? You said Houston Foreclose?
Ethan Gao 39:20
Flip the words. Foreclose Houston.
Andrew Chen 39:23
Foreclose Houston. Gotcha. How often does the list get published?
Ethan Gao 39:26
It’s every month. Although, we’ve had a few storms roll through. And when that happens and emergencies are declared, essentially what happens is some federal agency or something will come down and the banks will forestall their foreclosures.
After Hurricane Harvey, there was a few months where essentially there were very few foreclosures. And then we just had another storm recently, a big one, and so we’re in the midst of that.
Last month, there wasn’t that many opportunities at the auction when it just happened. There’s not going to be that many until probably next month. There’s usually a three-month reprieve type of thing.
Andrew Chen 40:09
Makes sense. So you have the list a few weeks in advance. It sounds like you’re driving to the property and also checking out the neighborhood.
Are you actually able to access the interior? Are they occupied?
Ethan Gao 40:20
Andrew Chen 40:21
You can never access the interior?
Ethan Gao 40:24
Correct. You’re not supposed to.
Andrew Chen 40:26
I see. What kind of assumptions do you then make in terms of how to construct your bid, since a lot of the potential cost that you’re going to incur is going to be inside?
Especially if the occupant is going to have to be forcibly removed, they may not be too happy. They might tear up the inside.
Do you just assume a worst-case scenario where you have to do a gut down to the studs and then rebuild?
Ethan Gao 40:58
No, you don’t quite have to do that. You just have a range of what you expect based on the type of house, the year of the house, and what you observe.
You can generally eyeball the roof. You can eyeball the HVAC system. You can eyeball the driveway.
You can certainly look up the year the house was built and the builder.
Sometimes what will happen is these distressed folks are under pressure. Not frequently, but a good amount of the time or a statistically significant amount of the time, the house is actually listed for sale by a realtor. So you could actually just go online.
I just look at it and say, “Okay, it probably looks exactly like what these pictures say because they got posted a month ago and this is not in the contract.”
We’ve done this a few times, under five, but we’ve bought properties that were listed and under contract to be sold, and they could not close before the foreclosure. So then we knew exactly what the market price was because some third party was wanting to buy it at that price. So then you more or less know what the market value is.
Andrew Chen 42:23
Interesting. So if there’s a transaction in contract but it just cannot close before the foreclosure, the foreclosure will still happen?
Ethan Gao 42:34
Andrew Chen 42:35
Will the person who is in contract, who is contracted to buy, will they show up and attempt to pay for it?
Ethan Gao 42:42
No. The title company will do a “bring-down” before they close.
And title companies will know. They can see when they request the payoff whether there was severe arrearage and stuff like that.
So they do enough usually. Some title companies aren’t as diligent as others, but theoretically, they should all do a “bring-down” before so they’ll know that they can’t close their transaction because a foreclosure has already happened and the title is about to change.
Andrew Chen 43:11
What does a “bring-down” mean?
Ethan Gao 43:15
I just mean almost like a bring-down good standing certificate or something like that. Essentially, a couple of days before, they’ll review the title and make sure no intervening liens or ownership has happened.
Andrew Chen 43:32
I see. And by that point, the foreclosure would have happened.
Ethan Gao 43:36
Yeah. Or the title company, they’ve got actual and constructive knowledge because usually the seller will tell them, “Hey, I’m being foreclosed on. That’s one of the reasons I’m selling this cheap.”
And then also, the title company, when they request the payoff statement from the lender, they’re going to see you’ve been overdue for two years. So they know that there’s an urgency to why they need to close before a certain amount of time.
Andrew Chen 44:02
I see. And the party who’s in contract to buy, they’re not going to be able to pay for it before foreclosure, so they typically are not the ones who are going to be able to buy it in foreclosure. Is that right?
Ethan Gao 44:17
No. The way to make money in flipping houses, you have to sell it to retail.
You can’t really sell it to investors. Investors are cheap. They’re not willing to pay top dollar, generally speaking.
In this country, I don’t know what the statistic is, but an overwhelming majority of people buy with financing.
Let’s say you are really interested in this house. It’s being foreclosed on. You’ve got $80,000 that you can put down, but you’ve got to borrow $320,000 from your bank to buy it.
You typically do not have $400,000 that you could bring to the auction and buy it there on the spot.
Andrew Chen 44:59
Make sense. In that connection, how does payment work at the auction?
Hopefully, you’re not bringing bags of cash. Are you bringing cashier’s checks that are just sufficient to cover the purchase price for everything that you would want to buy?
Ethan Gao 45:12
Cashier’s checks in a variety of different denominations. And then usually $10,000 in $100 bills because sometimes people will bid $1 over or it will be an odd number.
You might have 70-80 cashier’s checks and then $10,000 in $100 bills.
Andrew Chen 45:38
Is the security pretty good at these things?
Ethan Gao 45:41
There’s really no security. But in the few years I’ve gone, I haven’t seen any issues.
Andrew Chen 45:48
I see. Is it really just a crowd of investors with their envelopes of money and documents standing crowded around the courthouse steps and they’re raising their sign to say, “I want to buy it at that price”?
Ethan Gao 46:04
That’s how it usually works. Specifically in this county, it’s not the courtroom anymore because it’s gotten too large. It’s at a convention center.
And there’s about 10 trustees auctioning things off at the same time. So for the serious guys who are buying multiple at a time, we usually have to bring seven guys with us because we can’t be in two places at the same time.
So we have multiple guys bidding for us. And we’re all on a group text chat.
Andrew Chen 46:41
Oh, wow. I see.
Ethan Gao 46:43
The ones that are buying multiples all do that.
Andrew Chen 46:48
So they’re dividing and conquering. And you have a list of exactly the properties that you’re going to bid on and which ones you’re not going to bid on, and your reservation price, the max you’re willing to pay. And they’re just bidding up in increments based on how the dynamics are going?
Ethan Gao 47:03
Correct. And like with any bidding situation, I’m not saying we do this, but occasionally, if there’s somebody you really don’t like, you might want to just bid them up as much as you possibly can and then quit right before you think they’re going to stop bidding.
Andrew Chen 47:25
What if they’re doing the same thing to you and you end up being the high bidder?
Ethan Gao 47:29
That happens all the time. Any economics textbook will tell you how relatively small and enclosed the bidding situations would work.
Andrew Chen 47:46
So I assume you’re buying as is. And so does title transfer recording happen on the spot right there?
Ethan Gao 47:53
Not on the spot. What happens is once you pay, then the trustee will record a special warranty deed within typically two to three weeks of the auction.
Andrew Chen 48:07
Got it. Cool. Zooming out a bit, that’s really interesting background around the auction process from somebody who is doing it very regularly.
But after you win the property and you’re going in now to actually assess what has to be done, or even beforehand, if that’s really where the major analysis happens, when you analyze or evaluate a potential flip, broadly, what are you looking for?
What’s the mental checklist you’re running through, the characteristics that an ideal auction property has? And what are some deal breakers?
Ethan Gao 48:56
We need to start with the easy ones first. So, deal breakers.
We don’t like touching flooded properties. There’s a lot in Houston.
Because of that, sometimes people kind of bush leap, do a rehab, and then there’s still fundamental problems. Some buyers just won’t want to buy them. So you’re looking at a somewhat smaller pool of buyers.
And then a flooded property is just harder to fix than a regular property. So we try to avoid those.
In terms of what’s a good flip, it’s really the mantra “You make your money on the buy,” if you’re able to buy something cheap enough.
At this point, we’ve developed enough expertise in actually fixing the property pretty fast and pretty cheaply. It’s extremely hard to lose money buying it cheap enough.
And then in terms of rehabs, we’ve done anything from light rehab, paint and carpet, to very heavy $80,000 type of rehabs where you have to basically redo everything because the people lived in it so poorly or broke everything.
I would say again, the focus is on buying it cheaply enough.
And then also, to take one step back, the auction, it’s fine and it’s interesting. I think it’s not the ideal way of acquiring a property because you can’t hedge out the going inside risk.
You open the door. You go in. Roof looks great. It was built recently. The neighborhood looks awesome. The lawn is even mowed.
So you can make some statistical judgments that these people didn’t break everything in the house or leave it terribly. But then when you went in and you go inside and you open it and you go, “What the F?”
Everything is broke. There’s dog poop everywhere, dead animals.
You’re just like, “How did these people even live here?” That can definitely happen.
And then there’s also potential title issues. We can get some title reports pulled ahead of time, but you can’t quite hedge all the title risk because when you’re doing these title reports, they’re a little bit more informal and the title company is not really representing and warranting that they’re fully accurate and precise.
It’s very different than getting an actual title commitment on a closing. So there will be relatively low percentage title issues that could have a high dollar impact.
Andrew Chen 51:29
What are some examples of that?
Ethan Gao 51:30
There’s some HOA liens. We have homeowners associations here. Some homeowners associations are super hard to deal with.
IRS tax liens. If you’re not willing to wait them out, you’ll have to negotiate.
Sometimes people auction off a second lien. You thought you were buying the first lien, and then you accidentally bought a second lien. And now you have to go pay the first lien off in order to actually have proper ownership of the house.
Just various things like that.
I know we’ve gotten messed up quite a few times on property taxes where we thought the property taxes were paid, and they weren’t. Either our title search report missed them or whatever, and then we ended up having to pay an amount we weren’t budgeting for.
Andrew Chen 52:12
What kind of ballpark are we talking about? Five figures? More than that?
Ethan Gao 52:18
Low five figures.
Andrew Chen 52:19
I see. What can an investor do to mitigate that? Are there things that you can be more vigilant about?
How can you uncover that information, if not from this informal title search?
Ethan Gao 52:32
I think, honestly, with a large enough sample size, you’re just going to have miscellaneous errors happen. You’re going to have that even if you’re buying everything at an escrow title company, if you do enough transactions. But the probability and the frequency is just significantly less.
There’s basically two, in my mind, unhedgeable or very lowly hedgeable risks.
One is title. And two is what is truly going to be the rehab, because once you walk inside, it could look great on the outside, and you go inside and it’s awful.
Now, we’ve also had the converse happen. Looks like absolute dog crap on the outside, and then you walk in and you say, “Oh, wow. These people really took good care of this.”
Andrew Chen 53:23
I’m guessing those are rare.
Ethan Gao 53:26
I don’t know if they’re rare. They might be about the same. Again, I don’t keep the statistics on it, but we’ve definitely had situations where that’s happened.
Andrew Chen 53:35
I see. You mentioned a moment ago, you make your money on the buy.
Is the rough analysis that you look at the home based on your drive-by, you’re asking yourself, “What will this thing sell at retail when it looks really nice?”
You’re having some range estimate of the rehab, so you knock that off that ultimate sale price that you’re shooting for, and then you take another discount for the profit that you’d like to make. And that’s what your bid is for the auction.
Is that the rough mental model?
Ethan Gao 54:06
More or less.
Andrew Chen 54:09
I see. What are you targeting then in terms of your typical flip? What kind of return are you looking for?
Ethan Gao 54:18
If we don’t think we’re going to make at least 15 net, by which I mean we bought the property and all of our rehab and our accrued property tax and hazard insurance, HOA fees – let’s call that x – if we don’t think we’re going to make at least 1.15x net from the title company, we’re not interested.
Andrew Chen 54:41
Got it. Cool. And what have been some of the ranges that you’ve seen?
Ethan Gao 54:47
Our worst was probably out of 100, we lost money on three. The drawdown risk was extremely low. We’re talking about less than a 5% loss on each, so not like my crowdfunded story.
And then on the high end, the IRRs have gotten pretty high on certain ones, but they were more special situations.
I’ll give you an example. We did one. We bought it for x.
And then my partner showed up. It was in a specific township within the county.
They’re a lot more anal about stuff. They knew what was coming and they had already tagged the place, etc. So what we did was, instead of flipping it ourselves, we sold it to a wholesaler who then found another investor to buy it.
We probably made 1.07x, but we did that within two weeks of buying it. Our effective IRR was you multiply that by 26, so it was probably 100% IRR.
That doesn’t happen all the time. I think our median outcome is 1.15x to 1.20x in 3-5 months front to end period from when we purchased it to when we get the wire on the backend, when we sold it.
Andrew Chen 56:11
Gotcha. All right, Ethan. This has been super insightful, really interesting way to think about how to invest in real estate aside from your classic “buy and hold” investing.
Where can people find out more about you, your platform, your business? And also, what are you looking to do next in your business? How can folks help you with that?
Ethan Gao 56:32
Sure. You can just shoot me an email. I’m very responsive.
My email is just my name, ethangao at gmail dot com. We don’t have a website. I have a website for the financial practice that I have, but it’s not related to the real estate.
In terms of how can folks help me, nothing in particular really comes to mind other than occasionally what’s happened is people I know will want to get into real estate. And just by virtue of me being so conservative and having been through this before, I’m usually very negatively poopoo the crowdfunding or sponsors in general.
And then I offer them, “Hey, if you are actually interested in learning about doing this locally and being able to show up and just learn something, I would be open to having you invest with me. And then I’m willing to give you some sort of mentoring where I at least show you what I’m doing on this deal.”
And it’s funny. Several of my friends who are lawyers talked a really good game where they said, “Oh, yeah, I’m going to definitely do that.”
“And then maybe I’ll just do more of what you’re doing, and then maybe I’ll quit my job.”
So I’ve had a few folks invest in a couple of projects. And I hope they’re not listening. They’ve never backed it up and done any of that other stuff.
They very quickly lose interest and they get bogged down in their own personal and professional lives. And honestly, I think that’s probably better for them, especially as a professional financial advisor.
I think the vast majority of doctors, lawyers, engineers, high income folks are probably better off just excelling at their jobs and then having whatever portion of their net worth they want allocated to local investments or real estate to find a good local operator to invest with, whether that’s somebody like myself or somebody who’s actually doing the nitty-gritty or what have you. I actually think that that’s superior than investing in a syndication in many ways.
Andrew Chen 58:43
I’m so curious. What causes folks who nibbled with interest to suddenly do a U-turn?
Is it just that they see, “This is actually a lot of work and I don’t want to do all this legwork,” or is it something else?
Ethan Gao 58:58
Yes to all three.
Inherent inertia, number one. That’s the biggest factor of everything. That’s why a lot of people stay at jobs they hate, spouses they hate, etc.
Number two, they see it and they see that it’s actually quite a big pain in the butt. It’s not really something that you could do from your biglaw job particularly easily, unless you truly have the right people that you’re just trusting and investing your money passively with.
That is a model, which is fine. But for these folks, they were more interested in being active themselves. That’s why I wanted them to have the opportunity to watch what we were doing and tag along or at least get updates from me.
And then also, people get busy with their own lives. That’s very normal. You have an extra kid or get a promotion or something is happening with your wife or your husband.
It’s extremely easy to get bogged down in whatever else you’re doing and not focusing on a somewhat small percentage of your net worth and a business that you really don’t have any expertise in and realistically you’re not going to particularly get too much expertise in, other than knowing what the correlation is versus your job or versus the other stuff that you’re doing or versus the economy and whether or not you’re backing a good operator or not.
Andrew Chen 1:00:24
All right. Well, thank you so much again for taking the time to share your thoughts with us. I really appreciate it, Ethan.
Ethan Gao 1:00:29
Andrew Chen 1:00:30
Ethan Gao 1:00:31
Have a good one.
Thanks Ethan and Andrew. What is the skip tracing software that Ethan speaks to at the 17:18 mark?
Andrew C. says
Hey Rishi, Ethan didn’t say in our interview. But you could probably find out by Googling around and searching REI forums.