This morning’s headline in the Wall Street Journal: “Mortgage Rates Hit 5% for First Time Since 2011“.
If you’re thinking about buying or selling a dental practice in the next few years, it’s time to pay attention.
Interest rates are one of the market forces that drive dental practice values.
(Of course, the best way to increase your practice’s value is to improve its profitability. The more money you make in your practice, the more your practice is worth. But some of the variables that determine price are beyond your control.)
The basic reason that interest rates affect practice values is simple: when borrowing money is cheap because of low interest rates, buyers can afford to buy a bigger practice. Money has been cheap for many years now, but it’s about to get more expensive.
It’s therefore likely that practice values will be decreasing (slightly).
But things aren’t looking rosy on the buyer’s side either.
While it might make sense at first to wait for practice values to decrease, this is probably not the best strategy. When interest rates go up and borrowing money becomes more expensive, the actual cost to buyers also increases.
Let’s explore this in more detail.
As you know, interest rates tell you how expensive it is to borrow money, or, in other words, how much you will have to pay to the person or institution with the interest in the loan.
The rates that regular folks receive when they go to borrow money depend on the rate at which banks can borrow money, and those rates are set by the Federal Reserve, an independent institution created by Congress in 1913 to address bank panics.
One of the roles of the Fed is to address inflation and stagnation by adjusting the rate banks can charge each other for overnight loans. These rates filter down, both directly and indirectly, to affect the interest rates attached to loans for dental practices.
While monetary policy goes beyond the scope of this blog post, what you need to know is this: for many years now, interest rates have been set at historic lows. Now the market is bracing for them to go up.
What does this mean for practice values?
The interest rates attached to loans affect how much practice a buyer can afford.
The important concept is the Debt Service Coverage Ratio (DSCR), which banks use to determine whether a particular buyer can afford a particular practice. The income from the practice (and potentially from other sources that that buyer has independently of the practice) must cover all of the buyer’s expenses, including payments on debt. Generally, banks are looking for income to cover about 125% of the buyer’s expenses – a DSCR of 1.25.
Higher interest-rates lead to higher monthly loan payments for buyers, thereby reducing the potential cash flow to a buyer of a given practice. This reduces buyer-purchasing power, disqualifying some, and reducing the overall number of available buyers in the marketplace.
Imagine that you’re looking to purchase a practice for $600,000. A 10 year note for $600,000 at 4% interest will cost you $728,964 over the life of the loan. The same loan at 8% interest will cost you $873,558.
That’s a difference of $144,594! The difference in monthly payments is $1,205. This means that the doctor who borrowed at 8% has to earn an extra $1205 each month to take home the same amount of money as the doctor who borrowed at 4%. These market forces clearly affect what buyers can or will pay.
When interest rates go up, monthly debt service increases. If debt service goes up by $1,000, the buyer’s net income decreases by $1,000. Lenders are acutely aware of the additional drag on cash flow due to higher interest rates and they loan correspondingly lower amounts, which also drives down practice values.
Here’s the bottom line:
The best way to increase the value of your practice is to increase your revenue and take home income and keep it at a high level until you hand over the keys.
External factors do play a role in the value of your practice, but rate increases will not transform the market overnight.
That being said, if you’re thinking about selling a dental practice, consider selling now, before higher interest rates push the value of your practice down.
And if you’re ready to buy or sell now – or just have questions about your options – Integrity Practice Sales is here to help.
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