Are Capitalization Rates Really Constant within Housing Markets?

Capitalization (CAP) rates for residential real estate are generally assumed to vary with interest rates, expected appreciation, and a variety of other factors but not with the size or value of the unit. It is generally assumed that landlords can adjust unit size to increase supply in a size range where the CAP rates are high while lowering supply for size categories where the CAP rates are low. Such arbitrage should eventually equate CAP rates across size and value categories.This paper illustrates that, while the assumption of constant CAP rates is true for much of the housing market, in a model with market segmentation and inframarginal landlords, the CAP rate should decrease as house value gets sufficiently high. When this theory is tested, the CAP rate in Washington, D.C. starts decreasing as house value exceeds $600,000. The results imply that the CAP rates at the upper end of the housing market should be interpreted with caution and may explain problems in empirical tests using average the CAP rates for all residential units in an area. The theory also explains the paradoxical result that the fraction of renters in a segment of the market varies directly with the rent to value ratio of the housing