One of the items that can increase the cost of a project is the development fee. A development fee is often a multiple of the amount spent on development costs. To illustrate how the development fee works, think about a case where the developer is a separate company from the company that ultimately constructs the project. For this example, the sponsoring company that purchases the project from the developer is called the sponsor company. When sponsor buys the project from the developer the developer will want to earn a profit if the project has made it through difficult stages of permitting, achieving contracts, finding land and so forth. The profit the developer earns can be named the development fee.
If the development is made by the same company as the sponsoring company, then the question is why the development fee should not also be applied. This can be thought of as like a write-up of assets. Other situations where there may be write-ups of assets may be when a company has investments and those investments increase in market value. When an asset is written-up, the income must increase. In this case the increase in equity is non-cash.
Economics of Development Fees
The economics of a development fee are all about probabilities. As there is a high probability of failure in development projects, a developer must have some way to compensate the failed projects with a high profit on those few that succeed. In simple terms, if only one of five projects succeed, the profit on the project that succeeds must be five times the cost of the development for the project. When things get a bit more complex, you can think about different stages of project development. If the costs are small before projects are abandoned, the development process can be more profitable. The notion of evaluating probabilities in the development process is discussed in the video below and the associated video.
Development Fees and IRR
The development fee demonstrates problems with the IRR statistic. You may have heard general rules of thumb that the required IRR is highest during the development period and it declines as various stages of the project occur. But how can you evaluate the required IRR on an objective basis. This can be done by making a chart with various branches and probabilities and then computing the probability weighted net present value of the different trees. Finally, as the IRR is the number that makes the NPV equal to zero, you can back into the required cash flow in the success stem that produces a zero NPV.