As part of our family’s decision to relocate to Seattle, we went through the step this year of selling our orthodontic practice and the building in which the practice operated. Later this year I’ll have a more detailed summary of the process of selling a practice, but in this article I’d like to focus on the building practice valuation process, and what we learned.
The Practice and The Building
The sale of Kingwood Orthodontics involved two major components, the sale of the building, and the sale of the actual practice. Each was valued separately, by different people, and using entirely different metrics. And while the ultimate purchaser combined the purchase amounts into a single purchase price, it’s more elucidating to examine these two valuations separately.
Building Valuations: An Inexact Science
If you’re selling a residential home located in a neighborhood, there are literally dozens of comparable homes and recent sales by which even an amateur can reasonably accurately value your home. Therefore, obtaining a formal appraisal isn’t something that a seller would normally pay for, and typically only if the purchaser is financing their purchase will one be obtained at the behest of the lender. And even in those instances, the appraisal is largely a formality, as a brief internet search of comparable homes and recent sales will yield a relatively tight range of home valuations.
By contrast, valuing a commercial building with a specialized purpose (e.g. orthodontic practice) is the wild west by comparison. That’s because in many situations, the location of a dental or orthodontic practice is in a semi-residential area where there are simply not many other commercial buildings to compare it to. Reducing the applicable sample size yet further, there are typically only a handful of other dentists or orthodontists in a neighborhood, and few that will be in similarly situated real estate. That means the pool of ‘comparable buildings’ is virtually non-existent in most cases.
Thus, lenders turn to specialized commercial real estate appraisers to value the property. These commercial appraisers use specialized software that attempts to compile a sufficient number of comparable properties by either expanding the geographic scope of their search, or expanding the type of building considered comparable (e.g. including all medical related building types). This software based appraisal is then supplemented by an on-site visit to the property.
While all of this makes sense in theory, our actual experience with how this commercial real estate appraisal process plays out was less impressive.
Having conducted our own internet searches and knowing that there were almost no real comparable properties, I was initially optimistic that a manual visit by the appraiser would fill for the fact that there weren’t many comparable properties Having met the appraiser on-site it became quickly evident to me that this was merely a box-checking effort to confirm that the building did in fact exist, and that it was in approximately the same condition as the seller and buyer had described it previously to the lender. In total, the appraiser spent approximate 7 minutes inside the building. Thus, the valuation method was almost entirely reliant on trying to use comparables that weren’t really close matches in terms of geography, size, condition, or purpose.
Thankfully, our building valuation came back at a level sufficient to support the asking price and closing of the property. I, however, was generally surprised at what I perceived to be a lack of formality, and methodology employed in reaching a commercial valuation. That observation, I believe, might encourage the reader to seek out their own seller initiated commercial appraisal when selling a building, just so that there is more than one written valuation of the building.
Practice Valuations: Cash-flow Matters, Equipment Does Not
While the sale of an orthodontic or dental building is relatively rare, as most dental professionals lease office space, the sale of a dental practice, by contrast, is relatively routine. Despite that, however, there were still some surprises that I think are interesting to share.
First, the value of a dental practice seems largely determined by the valuation methods set by the lenders. That is to say, the number of dental practices purchased for cash is quite small, such that the pricing for dental practices has come to mirror a banks valuation methodology as opposed to how much a practice might appeal to an individual dental purchaser.
That distinction means that first and foremost what determines a practice’s valuation is free cash-flow. Things like the age of the dental equipment, how well it has been maintained, the quality of the staff, the reputation of the dentist in their community, how strong their network of referring dentists is, are all largely immaterial when determining for the practice valuation.
One pointed example is that Kingwood Orthodontics had just purchased a few months prior to the sale a $40,000 iTero intraoral scanner, which replaced the need to take dental impressions. The seller’s lender flatly informed us, however, that from the bank’s perspective, digital impressions are equivalent to physical impressions insofar as the both serve the same purpose of allowing the orthodontic practice to treat patients. And while the former might be more convenient to patients and in theory attract some additional new patients in the future, the fact that the practice owned the additional technology made no significant difference in the valuation of the practice.
So, if one were planning to sell their practice in the near future, he / she would be wise to forego investing in new equipment if that equipment is at all optional. And secondarily, the dentist should focus on increasing free cash-flow for the 24 months preceding the sale by eliminating any semi-personal expenses from the business, and working extra hard to develop additional revenue.
Rich McIver is the founder of Soar Payments, a merchant services provider that provides affordable credit card processing for dentists. His wife, Dr. Holly McIver is the founder of Kingwood Orthodontics.