Passive vs. Construction Investments – What Investors Need to Know?

In the world of real estate investing, private debt has emerged as an attractive asset class for those seeking stable returns and tangible security. But within this realm, there’s often talk about passive and construction investments. As an investor, you might wonder: what’s the difference, and more importantly, does it matter?

Let’s dive in and explore these concepts, with a particular focus on how Bowery approaches these transaction types.

Understanding Private Debt in Real Estate

Before we delve into the specifics of passive and construction investments, it’s crucial to understand the broader context of private credit (also known as private debt) in real estate. If you’re new to this concept or need a refresher, we’ve got you covered.

Check out our comprehensive guide “What is Private Debt?” on Bowery’s website for an in-depth exploration of this asset class, its benefits, and why it might be the right fit for your investment portfolio.

Passive vs. Construction Investments: An Overview

Now, let’s break down the two main categories of investments you’ll encounter in private debt: passive and construction.

Passive Investments: The Simpler Route

Passive investments are, as the name suggests, the more straightforward option in the world of private debt. These are typically loans secured by an existing property, where the borrower isn’t planning any construction or major development work. It’s important to note that both passive and construction deals from Bowery are secured against property that already exists. However, passive investments have some unique characteristics that set them apart.

For starters, passive investments often come with slightly higher loan-to-value ratios (LVRs) and lower interest rates. It’s all about simplicity and risk assessment.

With passive investments, we value the property in its current condition. The security for the investment is the property itself, plain and simple. This transparency allows for a clearer risk assessment right from the get-go.

Another factor that makes passive investments attractive is the straightforward exit strategy. If things don’t go as planned (which, let’s face it, very rarely happens with Bowery), there’s always the option to sell the property and recoup the investment. This built-in safety net adds an extra layer of security for investors.

All these factors combine to make passive investments generally simpler and less risky in the eyes of lenders and investors alike. It’s this reduced complexity that often leads to those higher LVRs and lower interest rates we mentioned earlier.

To put it in context, a land settlement loan is a classic example of a passive investment. Imagine a borrower who needs funds to secure a new property and prepare it for future development. The facility isn’t funding any major developments – they just need funds to purchase the property and secure necessary documentation. That’s a passive investment in action: straightforward, secured, and with a clear path to repayment.

Now, let’s shift gears and talk about construction investments. These are a bit more nuanced…

Construction Investments: The Complex Cousin

Unlike passive investments, construction investments fund the development of new properties or major renovations. And by its very nature they’re more complex because construction itself is complex.

When we’re dealing with construction investments, we’re not just looking at what’s there now – we’re envisioning what will be. These loans are based on what we in the industry call the “as if complete” valuation. There’s rigorous market analysis involved. We’re assessing the future value of a property that doesn’t quite exist yet, at least not in its final form.

The way these loans are structured for the borrower are different from passive loans. Instead of handing over a lump sum at the start, funds are typically released in stages as the project progresses. With each milestone achieved, more funding is unlocked for the borrower. This staged approach helps manage risk, ensuring that the project is on track before more money is committed.

This type of investment requires a keen eye and constant attention. Which is what Bowery is great at. Our team keeps a close watch on the project and supports the borrower as they navigate any unexpected challenges that arise.

But before we even get to that stage, construction investments demand more due diligence upfront. Bowery is sharply focused on the 4 C’s of Lending: character, capacity, collateral and capital. We look for borrowers who really know their stuff when it comes to construction investments. We’re talking about savvy developers who have been around the block a few times, with the experience to navigate the twists and turns of a construction project.

And it’s not just about experience – these borrowers need to be financially stable too. After all, construction projects can sometimes throw unexpected curveballs, and we need to know our borrowers can handle them without breaking a sweat.

It is important to note here that the world of construction investments is incredibly diverse. On one end of the spectrum, you might have relatively simple land subdivisions. On the other, you could be looking at complex high-rise apartment developments that transform city skylines. Each project comes with its own unique set of challenges, but also its own potential rewards.

The Investment Spectrum: The Obvious and Non-Obvious

The main difference between passive and construction investments boils down to risk and complexity. Passive investments are generally simpler to assess and manage. Construction investments, while potentially offering higher returns, come with more moving parts and inherent risks.

Now, you might be thinking, “Great, so I should just stick to passive investments, right?” Not so fast! Bowery’s approach makes things a lot more interesting…

Bowery’s Approach: Making the Distinction Less Crucial

At Bowery, we work hard to level the playing field between these two investment types and offer a more attractive proposition for our investors.

Risk Normalization: Our Secret Sauce

At Bowery, we believe that with the right strategies, we can normalize the risk across different investment types. This means that whether you’re investing in a passive loan or a complex construction project, your risk exposure remains relatively consistent.

How do we achieve this? It’s all about balance. We use a variety of levers to manage risk:

Adjusting Loan-to-Value Ratios (LVRs)

One of our primary tools for risk management is the careful adjustment of loan-to-value ratios. For passive investments, we might allow a higher LVR because the property value is known and stable. On the flip side, for construction projects, we typically set a lower LVR to account for the inherent uncertainties. This flexible approach allows us to calibrate the risk across different investment types, ensuring that no single project carries disproportionate risk.

Setting Stringent Borrower Qualification Standards

We believe that a strong borrower is key to a successful investment. That’s why we set high standards for our borrowers, particularly for more complex projects. For construction loans, we look for borrowers with a proven track record in similar developments and a robust financial position. By maintaining these high standards across the board, we add an extra layer of security to all our investments.

Requiring Pre-Sales for Construction Projects

When it comes to construction projects, especially larger ones, we often require a certain level of pre-sales before releasing funds. This strategy serves two purposes: it demonstrates market demand for the project and provides a level of financial security. Pre-sales essentially lock in a portion of the project’s future value, reducing the risk for our investors. It’s one way we bring construction investments closer to the risk profile of passive investments.

Incorporating Contingency Funding

Construction projects, by their nature, can encounter unexpected costs. That’s why we build contingency funding into our construction loans. This extra buffer helps absorb unforeseen expenses without putting the project (or your investment) at risk. While passive investments don’t typically need this buffer, including it in construction projects is another way we level the playing field between passive and construction investments.

Securing Additional Collateral When Necessary

Sometimes, to further mitigate risk, we may require additional collateral well beyond the loan value. This could be other real estate assets, personal guarantees, or other forms of security. By doing so, we can offer competitive rates and terms on investments that might otherwise be considered higher risk, bringing them more in line with the risk profile of simpler passive investments.

By tweaking all these factors, we aim to create a risk profile for construction investments that’s comparable to passive investments. It’s like setting the dials on a radio receiver to get the perfect signal – in this case, the perfect balance of risk and return. This approach allows us to offer our community of investors diverse investment opportunities without significantly altering the risk-return profile you’ve come to expect from Bowery.

The Investor Experience: Consistency is Key

So, what does this mean for you as an investor? Simply put, it means consistency. Whether your funds are going into a passive loan or a construction project, you can expect a similar level of risk and return.

We don’t want our investors jumping from a 6% return on one investment to a 12% return on the next. Instead, we aim for a steady band of returns – typically around 9.25% to 10.25% in the current market. This consistency allows you to plan and forecast with greater confidence.

Making Informed Decisions: Your Role as an Investor

While we work hard to normalize risk across investment types, it’s still crucial for investors to understand the nature of each investment. Here’s what you should keep in mind:

1. Due diligence is always important, regardless of the investment type.
2. Trust in your investment manager is key – make sure you understand and are comfortable with their risk management approach.
3. Remember that while we aim for consistency, no investment is without risk.

The Bottom Line: It’s About the Manager, Not Just the Investment Type

In the world of private debt real estate investing, the distinction between passive and construction investments certainly exists. But with Bowery Capital’s approach, this distinction becomes less critical from an investor’s perspective.

What matters more is the strategy and expertise of your investment manager. By carefully managing risk factors across all investment types, we aim to provide you with consistent returns and peace of mind, regardless of whether your funds are in a passive loan or a complex construction project.

Remember, in the end, it’s not just about choosing between passive and construction investments. It’s about partnering with an investment manager who can navigate the complexities of both, delivering steady returns while keeping risk in check. And that’s exactly what we strive to do at Bowery Capital.

Interested in learning more about our approach to private debt investments? Don’t hesitate to reach out. We’re always happy to discuss how we can help you achieve your investment goals.