Developer Fees: Dispelling Myths about a Vital Resource

As any seasoned member of the industry knows, developer fees are an integral component of the affordable housing pipeline, providing the operational backbone for any project utilizing Low Income Housing Tax Credits (LIHTC).

However, although they have long been an industry standard, the necessity of developer fees continues to be called into question by policymakers and members of the public. This has only increased in recent years, with the efficacy of the LIHTC program falling under heightened public scrutiny and developer fees in particular being interpreted as an excess cost in already pricey housing developments.

This criticism mainly hinges on a belief that development fees, and the LIHTC program more generally, stunts the construction of new housing, rather than stimulating the overall affordable housing supply.

Within the industry, however, experts maintain that developer fees are a vital tool in the fight to provide adequate affordable housing for all, supplementing limited cash flow and allowing units to be sustainably rented to low-income tenants.

What are Developer Fees?
Developer fees serve as compensation for a developer’s services on a project, designed to cover overhead expenses. They are calculated by taking a percentage of a project’s total development costs, and range from about 7 percent to 15 percent, depending on budget structure and local regulation. These fees are financed by an investor who, in turn, exchanges their immediate equity investment for tax credit benefits.

In general, developer fees are only paid out once a short-term construction loan is converted into a long-term permanent mortgage that will provide stabilization to a property. As well, other financial partners — such as syndicators and investors — will use a developer’s fee as a contingency against cost overruns and other unexpected developments in project timelines.

Developer fees are crucial, as developers rely on them to account for risk, loan guarantees and production of revenue.

“If you didn’t have a developer fee, there would be no reason to be a developer for affordable housing — you have to have some sort of compensation,” says says James Tassos, deputy director of tax policy and strategic initiatives at NCSHA. “It’s not profit — it’s what the developers use to keep the lights on. It’s how they pay their salaries; it’s how they do their market studies for the next development; it’s how they keep a pipeline of deals going.”

Additionally, developer fees can hedge against construction risks, further incentivizing the building of affordable housing. “We have issues with climate change now where more disasters are impacting deals,” Tassos says. “The developer fee is a way to compensate the developer for the work and the risk that they are undertaking.”

Patrick McAnaney, development director at Somerset Development Company, echoes these sentiments, explaining that developer fees are more accurately framed as revenue rather than profit.

“The same way if you had a restaurant, the sales of all your meals is your revenue, but then you have to take out labor costs, costs of goods sold, lease costs, and then whatever’s left over is your profit or income,” McAnaney says. “For most affordable housing developers, the developer fee is the main revenue that you make as a company. It helps pay all of your costs: your staff salary, your office lease costs, anything else. And then whatever’s left over once you’ve subtracted all of your expenses is your income or profit.”

The need for developer fees is unique to rent-restricted housing, as market-rate housing can generally rely on long term income growth from rising rents and an appreciation in value of the development. “One of the things that’s different about the LIHTC program from market-rate housing is that you can’t rely on appreciation or cash flow to generate compensation to the developer the way that you can in a market-rate context,” says Tassos.

Changes in Developer Fee Administration
Typically, states allow for a certain percentage of total development cost — commonly 15 percent — to be used to calculate a developer fee. However some states have begun reconsidering fixed-cost models due to today’s sustained inflationary environment.

Tassos says this stems from the COVID-19 pandemic and lingering effects on the housing industry. “There was a lot of disruption in material availability,” he says. “Supply chains were disrupted, so certain materials couldn’t be found, and if they could be found, they were typically at much higher costs. As a result, developers were having to come back to the state agencies two or three times because they needed additional credits to make their projects financially feasible, and every time the cost went up, the developer fee could go up as well.”

As a result, some states implemented a maximum dollar figure that could be received by developers, as they found percentage-based calculations to be excessive in some cases given new normal construction costs.

McAnaney cautions states against reactionary sticker shock, however, and argues that strong developer fees are still crucial to attracting sustained capital into the affordable housing market.

“For a bank to give a construction loan, they only want to give it to a developer who has enough resources available that if something goes wrong, they know they can count on those guarantees to get some sort of repayment,” McAnaney says. “The key thing is you need developer fees to be strong and robust enough to provide a stable revenue source so that you interest people. And then you’re going to bring in the developers who have that capital available, who can get construction loans and get tax credit investors interested. Without that, if you made developer fees really small, you’re just not going to attract any of those folks into the market.”

NCSHA’s current Recommended Practices in Housing Credit Administration (most recently published in October 2023), suggests that allocating agencies should “limit developer fees to the lesser of an appropriate defined per-unit dollar cap or 15 percent of total development cost, with limited exceptions for developments meeting specified criteria.”

Deferred Developer Fees: An Enticing Option
There are two primary types of developer fees: standard fees, in which developers receive the entire fee upfront, and deferred fees, in which part of the fee is deferred until after construction. This deferment involves delaying payout until later in a project’s life cycle in return for a slightly higher fee percentage. The percentage of deferred fee can range across projects, and depends on budget and operational needs. Developers typically view deferrals as a loan to the project, which they pay back with project cash flow over time.

Although deferred fees are nothing new, they have gained popularity over the past few years as a practical, easy strategy to provide quasi-gap financing to get projects over the finish line.

“You always want as much as possible to be paid and not deferred until later, but realistically, you only have so much project budget to work with,” McAnaney says. “Very rarely does a project have excess funds that they could pay all of the developer fees up front.”

Additionally, deferment can be included in eligible basis, thereby increasing total federal LIHTC proceeds and incentivizing local agencies with limited resources to go down the deferral route. “Let’s say I had a big project and my total developer fee out of that percentage calculation comes out to $8 million,” McAnaney says. “If I pay $2 million to the development team during construction, that means $6 million is deferred. You can generally get up to $2 million of federal tax credits on that $6 million, and that’s $2 million of federal tax credit that is a funding source during construction because the deferred fee is considered a valid project cost.”

To remain above board, the entire deferral must be paid back within the project’s 15-year LIHTC compliance period.

While they seem attractive at first glance, deferred fees also come with a degree of financial risk.

For example, McAnaney says “if the project isn’t generating a lot of income and your expenses are a lot higher than you expected, or your rents are a lot lower, or you have a lot of vacant apartments, then you may have to forfeit and pay back some of that federal money.”

Additionally, teams should spend time calculating an ideal percentage of fee to be deferred. Too much deferral can delay cash flow and create a financially tenuous environment, particularly for smaller developers.

NCSHA does not take a specific stance on deferred fees, with the exception of stressing that developers ensure they are always in compliance with the 15-year tax rule. Other than that, Tassos says teams should use whatever tools are at their disposal to strengthen housing pipelines.

“There are many reasons why developers want to defer fees,” Tassos says. “They might want to put some of the capital in the development as a sort of capital contribution and then take it later as cash flow allows. And that’s a reasonable approach for the developer, so we didn’t want to get into the business of regulating how much could be deferred, because it depends on facts and circumstances and it’s going to be different for different deals.”