To all the doctors who decided you didn’t want to borrow from the bank to pay partners because you wanted to build equity, here’s a harsh wake-up call: You just traded cheap, long-term debt for more expensive short-term debt that will result in depressed levels of cash out and reduced profits.

Take the example of a group of gastroenterologists in Texas, who claimed they had $9MM in equity because they had a $20MM property with only $11MM of bank debt. This group failed to consider the $3MM they owed retired partners who held notes receivable.

At the end of the day, “debt is debt” regardless of to whom it is paid. The group’s true equity in the property was $6MM and not $9MM. Moreover, the bank debt carried a rate of 4.50% to be paid over 25 years, while the debt to the retired docs was to be paid over 5 years at a rate of prime + 1% (9.25% at the time of writing). The annual debt service to pay the retired doctors under those current terms is approximately $750K.

If the property was leveraged up to pay off the retired partner debt, the same $3MM would have an annual payment of $200K.

That’s a cash flow improvement back to the current doctors of $550K per year for 5 years. The interest expense savings in the first year alone is more than $100K. But this raises a bigger question.

Are physician-owned real estate investments ever free and clear of debt? The answer is typically NO.

If there is a future obligation to buy out partners at retirement, the debt gets transferred from the bank to the partners at retirement in a 1:1 exchange, and as we highlighted above, the cheaper cost of capital is usually to the bank.

This elusive goal of being free and clear on physician-owned real estate investments is often misguided and usually results in underwhelming cash flows and distributions that are significantly reduced by partner buyouts.

The best way to truly know an entity’s best long-term debt structure is to create a model that forecasts planned buyouts, and use that forecast to make an assessment. CMAC utilizes its Mentes360 program to assess the best debt strategies specific to each group’s operating agreement, and partner succession plans, enabling our clients to better manage cash flows and maximize returns.

For information on how you can use Mentes360 to improve your practice, email support@mentes360.com.