Ahhh just worked out that the reason the lib project was being added as a useless non-expanding item was because I had the lib project open in another window. XCode gave me no indication that this was what the problem was, so I was lucky to stumble across it.
Once I had closed the other window I was able to add the lib project and it showed up correctly as an expandable subtree, as well as now being visible for selection in the app target dependencies.