Since 2008, the world has experienced a long period of strong economic growth, and historically low interest rates. During this time, the dental practice market was also in a boom period. Due to strong demand, availability of inexpensive capital, and the emergence of the Dental Service Organization and Consolidators, dental practice sales and prices reached all-time highs. The increase in values was further supported by the fact that most banks have become experts in lending to the industry and are very comfortable with aggressive lending due to good performance, and generally low loss rates. In fact, because of the banks’ comfort, they contributed to the rise of dental practice prices as they were willing to support qualified purchasers who offered strong premiums to acquire practices in competitive bidding situations.
Over the past 9 months, due to various economic factors including high inflation, there has been a dramatic rise in bank lending rates. Since March of this year the Canadian prime lending rate has risen from 2.45% to 5.95%. Since this market is heavily reliant on bank financing, it is likely that despite continued strong demand for practices and purchasers willing to pay top dollar, there may be a cashflow squeeze that may weed purchasers out of the market which will likely result in a decline of practice prices. While the performance of dental practices has proven to be stable with excellent returns, sales are increasingly based on practice cash flows versus the borrowing costs. Here are some examples of how this interest rate increase has affected cashflows, and may impact values.
Previously a $1,000,000 loan at 2.45%, amortized over 12 years would have annual payments of $107,833. Currently the same loan at 5.95% would have annual payment of$142,833, an increase of 32%. Despite this huge change indirect cash flows, since these lending rates are variable, and historically low, most cash flow models would not have used a historically low cash flow rate (2.45%), rather they would have used a more conservative figure to analyze and project cash flows (likely 5% or 6% to ensure that the borrower could absorb increases). Therefore, there would not have been as much of an impact on borrowing ability.
From a valuation perspective one of the major valuation methodologies is the use of discounted cash flow. This is a formula which calculates the value of an asset based on its cash flow discounted at the appropriate discount rate (sometimes called cap rate, hurdle rate or required rate of return). The discount rate is a complicated calculation which is essentially based on the risk-free cost of capital, the industry risk, and the specific practice risk. In the dental market, this discount rate is anywhere from 12% to 22% for an established practice (depending on a multitude of factors). Since the risk-free portion of the discount rate has risen by 3.5%,without any other changes to the rest of the factors it implies that the normal discount rate for dental practice would now be higher, resulting in a reduction in value.
While we expect that there will be an impact on values due to cash flows, this will likely be a moderate decline, rather than a large decline. The reason that it is likely to be moderate may be due to simple supply and demand economics. If sellers feel that they are unwilling to accept lower prices, there may be a lower number of practices available. Since purchaser demand continues to be strong, this may offset any price declines due to borrowing costs. In addition to the above, dental practices remain superior performing businesses with reproducible results, and perform well despite unfavourable economic conditions. The second important fact is that dental practices are generally looked at for their long-term performance, it is not an asset that is typically flipped, but developed over the long term. In addition, although past performance is a good indicator of future performance, many dentists have the skills, and are able to improve a practice by taking advantage of practice building opportunities and unlocking the potential that may be available. Although it is hard to measure potential, by seeing opportunities it may make the historical cash flow analysis less important.
A bigger value pressure may also be looming for dental practices, which may also have an impact on value. Over the past few years, there has been considerable pressure put on practices expenses, specifically labor and supply costs. These cost increases are somewhat inflation-based, supply-demand- based (shortage of good staff) and related to the increased use of PPE. These cost increases may also reduce the earnings of the practice and therefore, the value or sale price.
Instead of timing the market, a better option is to plan your sale, when the time is right. In order to maximize your return, you need to start planning early, and demonstrate that your practice profits are maximized and inline with comparable practices.
For the sellers out there, we don’t think it is practical to wait until interest rates fall again (they may never return), in order to time the market. Instead of timing the market, a better option is to plan your sale, when the time is right. In order to maximize your return, you need to start planning early, and demonstrate that your practice profits are maximized and in line with comparable practices. The market penalizes practices that have high relative expenses.
For the buyers, this possible adjustment may generate some opportunities, but I doubt that you will see major price reductions, as practices still represent an excellent investment with excellent returns. In addition, since bank financing is a major driver of a practice purchase, a buyer may be able to differentiate themselves by having some capital to inject instead of relying 100% on a bank loan.
Please send comments to colin.ross@ppsales.com.
Colin Ross is a Partner in Professional Practice Sales Ltd. (www.ppsales.com), which specializes in the valuation and sale of dental practices. He can be reached at (905) 472-6000 or 1-888-777-8825 or e-mail at: colin.ross@ppsales.com
