The financing of development costs and development fees can be a contentious part of project finance analysis. Development costs may or may not be reimbursable from a lender and considered as part of the borrowing base. A development fee is often a multiple of the amount spent on development costs and is tantamount to a sponsor buying a project with a notice to proceed from the developer. I often make a project finance analogous to a relationship and I say that the development period is like the dating period — it can be cancelled at any time. To illustrate how the development fee works, think about a case where the developer is a separate company from the investor that ultimately pays for construction of the project (the sponsor). 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 Costs and Development Fees
In living through the Corona virus, you have heard about developing a vaccine and the stages that must be completed before the vaccine is usable for the population at large. The first stage is research in the laboratory. Then, the vaccine is tested on monkeys after the research stage. After that there are tests with different numbers of human beings. After the third stage of human tests, the vaccine can be used. In valuing the drug company that makes the vaccine, the issue is probabilities. If the tests are passed, the market value of drug companies skyrockets as illustrated by the case of Modedra illustrated below. This valuation is not like cash flow. 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.
Illustration of development cost stages and value
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.