A “Development Fee” can refer to a charge for development management services. Commercial real estate developers can develop commercial properties as a service for a principal. The principal can either be a land owner or real estate investor. The real estate developer charges a fee for their services, typically as a percentage of the development cost. This fee is referred to as a developer fee, and loosely as a “development fee.”
Anyone who is investing in a commercial real estate deal should take the time to really understand how their money will be spent. This is a critical step in the due diligence process that many people overlook. Instead, they look at the total project costs without requesting a detailed breakdown of acquisition costs, hard costs, soft costs, and the developers’ fees.
The first three buckets are important to understand in their own right, but they’re especially important given that most developers’ fees are calculated as some percentage of the other three costs combined.
In this article, we take a look at the different types of real estate developer fees, including the role of these fees and what you might expect them to cost.
Types of Development Fees
There are generally four types of development fees to be aware of when analyzing a commercial real estate investment opportunity:
This is the fee that a commercial real estate developer charges for finding and facilitating the acquisition of the parcel slated for redevelopment. The industry standard tends to be about 1 percent of the purchase price. Most developers will insist on taking an acquisition fee, which is typically used to cover the compensation of the acquisitions team.
The development fee, also sometimes referred to as the “construction management fee,” is the fee a real estate developer takes to oversee the entirety of the development project, from pre-construction (e.g., the design and entitlement processes). This fee is generally used to cover corporate overhead and sometimes contributes to the developer’s profit for the project.
Some real estate developers outsource this project management capacity to a third-party firm that has no equity in the project. These fee-for-service development partners generally charge a flat monthly fee for their work.
Regardless of whether construction management is handled in-house by the developer or outsourced to a third-party provider, investors can reasonably expect to see development fees in the range of 3 to 5 percent of total project costs (acquisition + hard + soft costs).
General Contractor Fee
This is an additional fee, ranging from 3 to 4 percent of hard costs only, that is tacked on to the project by the general contractor. As a rule of thumb, if the real estate developer is ALSO serving as the general contractor, this fee should be at the lower end of that range, given that the developer is already taking its own fee. However, it is common for real estate developers (particularly on large projects) to outsource GC responsibilities.
The GC fee covers costs such as bidding out construction documents to suppliers and subcontractors, negotiating subcontractor agreements, providing due diligence related to subcontractor selection, and any other costs incurred during the design phase. The GC fee is also the profit the general contractor expects to make during the construction phase for their role in overseeing the physical construction of the project.
Considerations When Evaluating Fees
When evaluating developer fees, there are a few important considerations to keep in mind.
First and foremost, you’ll want to understand how many fees the developer is charging and whether these fees are in line with the industry averages as noted above. In a particularly complex project, for example, a large mixed-use development that requires new zoning and a lengthy political process, it might be reasonable to expect a higher development fee than a developer overseeing a smaller as-of-right project. The point here is to allow for some flexibility, within reason, depending on the nature of the deal.
Next, consider whether there is a proper alignment of interests. Does the developer seem solely motivated by the fees, or do they truly care about the success of the project? One way to facilitate the alignment of interests is to prohibit the developers’ fees from being used toward their equity in the deal. Instead, require the developer to leverage other funds to invest in the deal to ensure they have real “skin” in the game.
Lastly, we recommend structuring the deal to control for when (exactly) a developer earns which fees. From an investor’s perspective, you’ll want to see as much of the fee back-loaded as possible, thereby keeping the developer motivated to complete the project as planned. A common structure is to release 25 percent of the developers’ fees upon closing the deal, 50 percent paid pro rata with hard cost draw-down, and 25 percent paid upon stabilization.