Interest Rates Affect on Practice Values – Why now is a good time to Buy!
By Rod Johnston, MBA, CMA
Owner and Principal, Omni Practice Group
Some of you may remember, others were not born yet, but back in October of 1981, interest rates on home loans were 18.91%. Over the years, interest rates have gone up and they have gone down. In the early 2020s, we saw some home mortgage rates go as low as 2.81%. If you were wise, you borrowed as much as you could at that time and bought a house, even though you may already have one. Coincidentally, home prices typically do not follow interest rates. In fact, there have been periods of time over the past fifty years where interest rates have gone up and the average house price also went up. The same isn’t true for the value of practices.
When I first got into helping doctors sell their practices in the early 2000s, interest rates for practice loans were about 7.5%. Most of the terms on those loans were 7-year terms. Meaning you had 7 years to pay off or amortize the loan. What does that mean for practice values? Banks determine how much they will lend based on cash flow after debt service. Debt service is the amount of your monthly loan payments.
To calculate cash flow, you start with the net income on last years’ tax return. Banks typically use 2-years tax returns, brokers when valuing a practice use 3 years of tax returns. I’m using one year’s tax return to keep it simple. You take the last year’s net income of the practice and then add back the non-operational expenses. Those expenses are those that may not be necessary to run the practice. Expenses could include gifts to employees, a continuing education class a seller took in Hawaii to get a vacation along with the CE, or meals they expensed for practice. You can stop those expenses and still run the practice.
This gives you an adjusted net income for the practice. You then subtract your annual debt service to get the cash flow number. The banks then divide the cash flow after debt service by the annual debt service to get a debt service ratio number which should be above 1.2 times the debt service. So, if your cash flow is $120,000 and your debt service is $100,000, your debt service ratio is $120,000/$100,000 = 1.2 times your cash flow. Anything lower than that and the loan would be rejected, or you would need to figure out how to make the numbers work to get the debt service ratio up.
What does this have to do with practice values? Well, if interest rates go up, that’s going to cause a buyers debt service payments to go up. An increase in debt service will result in a decrease in cash flow after debt service. This will result in the debt service ratio going down and possibly dropping below the threshold of 1.2 times cash flow after debt service. The same goes for the term of the loan. Some banks now have 15- or 20-year terms on their practice loans. This reduces the debt service payments as the loan is spread out over more years. The result is a decrease in annual debt service payments which improves cash flow. A bank with a 7-year term may not get the loan approved, but a bank with a 15-year term may be able to do it.
Brokers know all this stuff. When good brokers do their valuations, they’ll do a check to make sure the bank will be able to finance the practice at a certain value. So, they’ll do a debt service ratio calculation and if it falls below 1.2 times debt service, then they should lower the value to price it correctly.
The good news is that there was a recent drop in practice loan interest rates. Interest rates on practice loans are between 5% and 5.5% at the moment. As a buyer, this means the cash flow after debt service is improved with lower interest rates. Because the lower interest rate resulted in lower debt service payments which helped increase the debt service ratio. In addition, lower interest rates will lower a buyers’ monthly payments as well. This may help you get into a practice that you may not have been able to purchase in the past as the ratio now works with the lower interest rate. This can be especially good in a startup scenario or in larger practices.
In summary, remember that when interest rates are low, which they are at the moment, it’s a good time to think about buying a practice. You may be able to get into a better cash-flowing practice with the same or lower payments than when you buy when interest rates are higher.
If you would like a free consultation on buying a practice, please contact one of the Omni brokers. We are always glad to help. Phone calls are always free. We are also having a buyer’s webinar on October 10th, 2024, and a seminar on November 1st, 2024, in Bellevue, Washington, where you will be educated from beginning to end on how to purchase a practice and why you should buy a practice.