Bifurcation in Real Estate: A Market at a Crossroad

Bifurcation in Real Estate: A Market at a Crossroads

Bifurcation: A point at which something divides into two branches or parts.

Real estate is an asset class, and like all asset classes, it has distinct relationships and subdivisions. Each asset class is bifurcated based on type and composition.

In real estate, the two primary bifurcated classes are Commercial and Residential. Historically, the key factor linking these two asset types has been interest rates—which dictate both the cost of housing and the return on housing investments.

The Pre-Pandemic Relationship: Interest Rates as the Link

Prior to 2020, the residential real estate market followed a predictable formula:

• The cost of housing was largely determined by the yield curve, a benchmark created by investment banks to measure risk vs. maturity.
• The risk-free rate of return was set by the Federal Reserve System, influencing mortgage rates.
• Residential home values followed the classic “3L” principle: Location, Location, Location.

Everything functioned as expected—until the pandemic of 2020 disrupted this equilibrium.

Pandemic Shock: The Breaking of the Traditional Relationship

During COVID-19, the Federal Reserve slashed interest rates to near zero. This had two immediate effects:

1. Residential housing prices surged—low mortgage rates made homeownership cheaper, fueling demand and driving up prices.
2. The Commercial market weakened—as remote work became mainstream, many businesses abandoned office spaces, leading to lease cancellations and rising vacancies.

For the first time, the long-standing relationship between Commercial and Residential real estate came under strain.

• Residential buyers took advantage of lower mortgage rates and migrated to more affordable locations while working remotely.
• Commercial landlords struggled as office space demand plummeted. With lease cancellations rising, many property owners faced mortgage defaults.

Commercial vs. Residential: Two Paths in Distress

The structural differences between Commercial and Residential real estate became more apparent:

• Residential Foreclosure Process: A structured, standardized legal process exists for homeowners facing default.
• Commercial Properties & Bankruptcy Protection: Commercial owners, protected under Chapter 11 bankruptcy, often operate under LLC or LLP structures, allowing them to renegotiate loan terms rather than face immediate foreclosure.

This ability to delay liquidation has given commercial investors more flexibility in managing distressed properties—unlike homeowners, who are more exposed to financial hardship.

The Current Market: Stress Signals Emerging

As of early 2025, the bifurcation between Commercial and Residential markets is showing signs of stress:

• Residential Market:

  • Home affordability is under strain due to rising financing costs.
  • Inventory is increasing, leading to gradual price declines.
  • Insurance costs are becoming a major burden, especially for aging baby boomers looking to downsize.

• Commercial Market:

  • Capitalization rates (Cap Rates) are rising as property values adjust downward.
  • Investors are waiting for Cap Rates to hit a favorable level before making acquisitions.
  • Multifamily properties remain attractive, as renters have limited alternatives in the face of high home prices.

Cap Rate Formula:

$$\text{Cap Rate} = \frac{\text{Net Operating Income}}{\text{Property Price}}$$

(Example: $200,000 NOI ÷ $4,000,000 Property Price = 5% Cap Rate)

Multifamily as the Safe Haven

With affordability pressures keeping many renters in place, multifamily properties are the top target for commercial investors. As multifamily demand rises, service-oriented businesses such as retail centers, medical facilities, and pet care services tend to follow.

But this dynamic will shift once residential home prices drop—triggering broader market adjustments.

The Federal Reserve’s Next Move: A Pivotal Moment

Between July and September 2025, the Federal Reserve is expected to make a critical decision on interest rates. If inflation slows, rate cuts will follow, directly impacting:

• Residential Housing: Lower rates will improve affordability, stimulating homebuying activity.
• Commercial Real Estate: As financing costs ease, investors may return to office and retail assets.

Warren Buffett’s Signal: A Cautionary Note

Market cycles often provide early warning signs, and Warren Buffett’s recent strategy is worth noting:

• Buffett has increased his cash position to over 25%, signaling caution.
• He is buying short-term government bonds while reducing equity exposure.

This flight to safety suggests that smart money is bracing for further economic turbulence before committing capital to real estate.

The Takeaway: Navigating the Bifurcation in 2025

The real estate market remains in a delicate balance between residential affordability challenges and commercial market corrections. Savvy investors are waiting for the right entry points, while homeowners face increasing pressures from rising costs.

At Pacific West Advisory Group, we specialize in helping investors navigate these complex market shifts. As we continue to push beyond traditional industry standards, our goal remains to deliver innovative and strategic real estate advisory services.

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The Problems are the Path: Residential Inventory Building Commercial Real Estate Revival

It will remain to be seen in the upcoming months if the Trump Administration will help the residential housing industry by increasing inventory and improving affordability issues.  The Commercial Real Estate industry appears to rebonding from the depressed levels and excess inventory.

Returning back to the work place will put additional pressure on residential housing.  The potential from higher interest rates for a longer period could put pressure on price and more inventory could accumulate.  That would create some respite in prices and help affordability.

There may be one pressure point for increased sales of the Retired Baby Boomer residentials. INSURANCE, the increases in California insurance is nothing when compared to other states.  The San Jose Mercury News recently had an article on insurance increases in all 50 States.  California has lower percentage increase than Florida and Texas, and lower than most other states, except a few.  Will a retired Baby Boomer sell and move to another state for lower insurance prices, simply due to lower home prices?  

What about the first time home buyer, where do they move?  The best answer lies in the profits of builders.  This is the sector of housing that develops new housing projects.  All one has to do is open the weekend San Jose Mercury News and the section with Housing Developments from south of San Jose to the east up to and including Reno.  Projects are for sale. Projects with incentives for buyers as mortgage rate buydowns. price cuts, improvement packages.  While builder's profits are increasing, so is there inventory of homes for sale. Price cuts and special terms create sales.  This draws buyers from areas where prices a high and inventory is low.

That is not enough to increase inventory enough to get affordability into the picture.  Affordability will only happen with economic benefits.  So we are now looking at the Trump Administration to create a viable economy with the ability to make housing affordable.  The major factor in affordability is NOT PRICE!  The Major Factor in Affordability is the COST OF MONEY.....INTEREST RATES!  If Trump is able to lower interest rates it will not make any difference if the price of the home is $1.5 million or $2 million, $700,000 or $800,000.  What will make the difference is how much a month the buyer pays for the mortgage, property tax and insurance. 

If there is Motivation in the California State Legislature it will be in the Rental Market of Residential Housing.  At present there are many rules on how a landlord may treat a renter.  Unfortunately, there are many landlords who are ignorant of the laws and their ignorance creates violations.  What is lacking here is equal representation of a renter to a buyer in the disclosure process.  At present a landlord, agent or management company can tell the renter the house is ready to move in, while the buyer of a residential structure must be shown documented forms that the property IS READY TO MOVE INTO!

I believe if the rental market of residential homes is regulated like the sale of residential homes there will be an inventory of substandard homes in the housing market. Landlords reluctant to follow Full Disclosure Laws may take an option of selling the residential property and exchange the proceeds to commercial income property that is not residential through a 1031 tax free exchange.

When the State of California overhauls the rental market with the same standards of the residential full disclosure sale market the housing inventory for sale will increase.

Back to Interest Rates, the FED met January 28 and 29 on interest rates.  No change with the note that inflation remains high.  This is an indication we will see the present level of interest remaining the same for at least the next 3 months, in my opinion. The forecast is for two cuts in 2025 looks to be accurate.  Consumer confidence has declined in past two months which may put pressure on the FED to lower rates.  Then we have President Trump.

President Trump made it Very Clear at his Zoom Call in Davos Switzerland interest rates are too high and must come down on a world wide level.  The cuts in Federal Employment by him will have some affects on economic numbers.  The Census has already announced a slow down in manufacturing.  The Recent Report has some figures that do not bode well for the economy.  Manufacturing is down and so is economic activity. The recent sell off in the stock market will have the FED taking a steady attitude on interest rates.  

The Year Curve, or the rates on government bonds from short term to long term rates have a steady increased in rates from one year maturity onward.  That to me, that means rates will come down with in the year and be less than the 10 year bond yield.  The Ten-year bond is the maker of mortgage rates and credit card rates.  The rates are seen on www.CMBC.com, on the Bond Tab.

As I observe real estate prices I begin to notice that properties are longer on the market, price cuts are becoming more common and sales are less that list.  Rent prices are seeing the same in price cuts.  The actual rent is not covered by either MLS listings or sources like Zillow.  With all the cuts, activity is still very active.  Sales may take longer, sale prices maybe less than a year ago; but residential homes are selling!  What I see as being a precursor of lower asking prices is that if I take the cost of owning a home in Mortgage payments and compare it to a similar property for rent.  The rental is the same or more than ownership cost. 

Lower cost of living in residential housing will result in the FED lowering interest rates.  Helping affordability.

The Commercial Real Estate Market is seeing light at the end of the tunnel.  Investors who once shunned the beleaguered U.S. Property Market are coming back!  U.S. Office-Building Sales increased 20% from 2023 to $63.6 Billion.  With a large cash reserve the investors are expected to see sales activity to accelerate in 2025.  Norges Bank Investment Management, the Norwegian Sovereign Wealth Fund,  purchased last year 50.1% of eight properties in Boston, San Francisco and Washington D.C. at a value of $1.9 Billion.  Last year it also purchased an office Building on Sand Hill Road in Menlo Park, CA.  Venture Capital haven for Silicon Valley bodes well for the outlook in Silicon valley for new business startups and employee growth.

New York City is seeing a bigger growth in office building purchases exhibiting the tunnel maybe be getting behind the Commercial Property Market.

Led by a bevy of big-ticket tech deals, office leasing volume in Silicon Valley has soared to 2.4 million square feet in the fourth quarter, the first time the quarterly total has topped 2 million square feet since Q2 2019.

A leasing surge of more than 4 million square feet in the second half of 2024 pushed the full-year deal; volume over 5.5 million square feet in Silicon Valley, setting the stage for a potentially robust office recovery in 2025.

The overall office availability rate in Silicon Valley dropped by 160 basis points, or 1.6%, to 25.9% in the fourth quarter, down from 27.6% in Q3 2024.  Available sublease space in Silicon Valley totaled 6.6 million square feet at the end of 2024.  A drop of 25% from 8.8 million square feet available at the end of 2023. 

As before, call or write for any question you may have and think of me of your "in the know real estate professional".