Why Real Estate Investing Returns Are Often Lower Than You Think

The Real Estate Myth Nobody Wants to Debunk

Real estate investing has a branding problem — not because it's a bad asset class, but because the version most people see is heavily curated. Purchase price. Rental income. Appreciation. The numbers that make it onto YouTube thumbnails and investor pitch decks are almost always the ones that look good. The numbers that don't — vacancy costs, depreciation recapture, unraised rents, six-figure renovation bills before a sale — tend to stay off camera.

Graham Stephan, a real estate agent and investor who built a seven-property portfolio across Southern California starting in 2011, recently did something most successful investors avoid: he ran the actual numbers and shared them publicly. The verdict was uncomfortable. Despite buying at the right time, locking in 30-year fixed mortgages at roughly 3%, and watching significant appreciation across his portfolio, his real annual returns worked out to around 4 to 5% per year — roughly the same as a Treasury bill, without any of the liquidity, tax simplicity, or peace of mind.

This isn't a cautionary tale against real estate. It's a more important story: about the gap between paper returns and real-world returns, and why that gap is so consistently underestimated by new and experienced investors alike.

---

The Hidden Cost of Being a 'Nice' Landlord

One of the most expensive decisions Stephan made wasn't a bad purchase or a risky renovation. It was a policy decision: he chose not to raise rents.

His reasoning, at the time, was logical. He'd locked in low prices and low rates. His tenants paid on time. Why create friction? The philosophy of maximising goodwill over maximising every dollar made intuitive sense — until the economics of property ownership shifted underneath him.

In California, many residential rental properties fall under rent control ordinances, which cap annual rent increases at a small fixed percentage — typically around 3% in Los Angeles. Crucially, if a landlord skips an annual increase, they cannot retroactively apply it. Future increases are calculated from the lower base. Miss a few years, and the compounding effect is severe.

Stephan estimates that years of forgoing rent increases — combined with a three-year Los Angeles ban on rent hikes during the pandemic period — resulted in rents sitting significantly below market rate. When he eventually went to sell, this didn't just hurt monthly cash flow. It reduced the sale price by approximately $100,000 on at least one property, because commercial and residential investors typically value income-producing properties based on a multiple of their net operating income. Lower rents equal lower valuations, regardless of what the property would fetch on the open market to an owner-occupier.

The lesson is precise: charging fair, market-rate rent isn't predatory — it's operationally necessary. A landlord who doesn't raise rents isn't being generous in a sustainable way; they're quietly subsidising tenants while absorbing all the risk of ownership.

---

Repairs: The Budget Line That Always Surprises

The standard advice — budget 1% of the property's value annually for maintenance — sounds reasonable until you've actually owned a property for a decade. The problem isn't the average. It's the distribution.

Maintenance costs in rental properties don't arrive in predictable, evenly-spaced increments. They cluster. You can go three years with nothing beyond minor issues, and then face a single calendar year where the roof needs replacing, the HVAC fails during a heatwave, and a plumbing inspection uncovers work that wasn't anticipated. A single such year can easily consume the entire annual profit from a property — and sometimes more.

Stephan cites one illustrative example: a property management company sent him an $800 invoice to repair an ice maker on a refrigerator worth roughly $400. The correct decision — haul it out, buy a new unit — would have cost $900 and solved the problem permanently. Instead, the repair was made on a depreciating appliance, at double its value. Multiply that kind of decision-making across a portfolio managed by third parties, and the cost accumulates rapidly.

Property managers are essential for investors who aren't hands-on, but they are intermediaries, not owners. Their financial incentives don't always align with yours. Building in a repair reserve of 1.5% to 2% annually — particularly for older properties or those in high-cost urban markets — is a more realistic baseline for long-term modelling.

---

Annual Returns vs. Paper Appreciation: A Critical Distinction

One of the most common errors in real estate investing is conflating appreciation with return. They are not the same thing.

Appreciation is an unrealised gain. Until a property is sold, that increase in value cannot be deployed, compounded, or spent. In the meantime, the investor is still paying insurance, property taxes, maintenance, and management fees — all in real, spendable dollars. Pointing to a property's current market value when asked about investment performance is, to put it plainly, not a complete answer.

When Stephan backed out all the true costs — vacancy periods, insurance increases (which reportedly doubled post-2020), repair bills, utility costs, and the time value of capital tied up in illiquid assets — his actual annual return landed at approximately 4 to 5%. For context:

• The S&P 500 has returned roughly 10% annually on average over the long run, with no tenants, no toilets, and near-instant liquidity.
• 10-year US Treasury bonds have offered 4%+ yields in recent years with zero management overhead and full federal backing.
• Index funds require no insurance renewals, permit filings, or contractor negotiations.

This doesn't mean real estate is a poor investment. Leverage — the ability to control a $400,000 asset with a $80,000 down payment — can dramatically amplify returns in rising markets. But leverage cuts both ways, and when illiquidity, tax complexity, and operational overhead are factored in, the risk-adjusted return on a poorly-optimised rental portfolio can easily underperform simpler alternatives.

---

Depreciation Recapture and the California Tax Trap

For investors who've owned rental properties for several years, there's a tax sting waiting at the exit that is widely misunderstood.

The IRS allows landlords to depreciate the structural value of a residential rental property over 27.5 years. This is a non-cash deduction that reduces taxable income each year, making rental income look smaller on paper. It's one of the features most commonly cited as a tax advantage of real estate ownership — and it is, while you hold the property.

But depreciation is a deferral, not a forgiveness. When you sell, the IRS applies what's known as depreciation recapture, taxing those previously deducted amounts at a flat rate of up to 25%. Investors who haven't planned for this often face a tax bill significantly larger than they anticipated.

For California-based investors, the situation is compounded further. California taxes capital gains as ordinary income — meaning the state rate, which can exceed 13% for high earners, stacks on top of the federal liability. An investor in a high bracket selling a long-held California rental could face a combined federal and state effective rate of 35% or more on certain gains, before accounting for depreciation recapture.

The most common mitigation strategy is a 1031 exchange — a provision allowing investors to defer capital gains tax by rolling proceeds into a like-kind investment property within specific timeframes. However, 1031 exchanges come with strict rules, tight deadlines, and the requirement to remain in real estate. For investors exiting the asset class entirely, as Stephan chose to do, the tax liability is simply the cost of exit.

---

The Hassle Factor: The Cost That Never Appears on a Spreadsheet

Ask most real estate investors what their time is worth, and they'll give you a number. Ask them how many hours per month they spend managing their portfolio, and the answer is usually vague.

Even with professional property management in place, ownership carries what might be called a persistent administrative overhead: insurance renewal reviews, property tax appeals, city compliance inspections, rent registry filings, utility account management, permit applications, and the steady stream of decisions that a property manager escalates to the owner. None of these are catastrophic individually. Collectively, they represent a recurring draw on mental bandwidth that doesn't appear in any ROI calculation.

For investors who are co-located with their properties and enjoy the operational side of real estate, this overhead may be acceptable — even enjoyable. For those managing properties remotely, across multiple cities or states, or who are at a stage of wealth where their time carries significant opportunity cost, the calculus changes substantially. A 4 to 5% annual return on capital that also requires consistent time, attention, and decision-making is a fundamentally different proposition than a 4 to 5% return that requires nothing beyond a quarterly statement review.

---

What This Actually Means for Real Estate Investors

None of this analysis suggests that real estate is a poor investment category. Stephan himself says he would likely buy again — under the right conditions: a property close to where he lives, manageable in scale, and suited to his current bandwidth. The early properties he purchased, acquired at distressed prices with low fixed-rate financing in a rising market, generated exceptional wealth. That's not revisionist history.

But the conditions that made those deals work — deeply discounted purchase prices, historically low mortgage rates, strong rental demand, and a decade-long appreciation cycle — are not the current conditions. Investors entering the market today face higher prices, higher financing costs, and more complex regulatory environments in major urban markets. The margin for error is narrower.

The practical takeaways for anyone evaluating rental property investing are clear:

• Model cash-on-cash returns, not just appreciation. If the deal doesn't work at current rents and current rates, future appreciation is speculation, not investment.
• Raise rents annually. In rent-controlled markets especially, failing to take permitted increases compounds into significant losses over time — in cash flow and in eventual sale price.
• Budget conservatively for repairs. The 1% rule is a floor, not a ceiling. Properties over ten years old in high-cost markets warrant higher reserves.
• Understand your full tax position before selling. Depreciation recapture and state capital gains taxes can meaningfully reduce net proceeds. Model this before making exit decisions.
• Price your time honestly. If the risk-adjusted, time-adjusted return of a rental portfolio doesn't exceed simpler alternatives, the portfolio deserves scrutiny — regardless of how strong the paper appreciation looks.

Real estate has genuinely built generational wealth for millions of investors. But it has also disappointed many who underestimated the full cost of ownership and overestimated what the numbers on a listing sheet actually promised. Running the real numbers — including the ones nobody puts in the thumbnail — is how that gap gets closed.

---

This article is for informational purposes only and does not constitute financial advice. Always consult a qualified financial professional before making investment decisions.

---

Frequently Asked Questions

What is depreciation recapture in real estate, and how much does it cost?

Depreciation recapture is a tax applied when you sell a rental property on which you previously claimed depreciation deductions. The IRS taxes the recaptured amount at a maximum rate of 25%, separate from the standard capital gains rate. If you've owned a property for many years and claimed significant depreciation, this can result in a substantial tax bill at the point of sale — one that many investors underestimate when planning their exit strategy.

Is the 1% rule for maintenance budgeting still accurate for rental properties?

The 1% rule — budgeting 1% of a property's value annually for maintenance — is a rough starting point, not a reliable ceiling. Older properties, properties in high-cost urban markets, and those that have been tenant-occupied for extended periods often require significantly more. A more conservative approach for long-term modelling is to budget between 1.5% and 2% annually, with an additional capital reserve for large, infrequent expenditures like roof replacements or HVAC systems.

How does rent control affect property values when selling?

In rent-controlled markets, the value of an income-producing property is typically assessed based on its net operating income — which is directly tied to the rent it generates. If rents have been held significantly below market rate due to rent control restrictions or a landlord's choice not to take permitted annual increases, the property will appraise and sell for less than a comparable property with market-rate rents. This impact on sale price is separate from, and in addition to, the lost monthly cash flow from below-market rents.

How do real estate returns compare to index fund investing after accounting for all costs?

This depends heavily on the specific deal, market, and holding period. In an optimised scenario — low purchase price, strong leverage, rising rents, minimal vacancy, and efficient management — real estate can meaningfully outperform broad index funds. However, when factoring in the full cost of ownership (repairs, insurance, property management, vacancy, taxes, and the opportunity cost of illiquid capital), many real-world rental portfolios generate risk-adjusted returns closer to 4–6% annually. The S&P 500 has historically returned approximately 10% annually over the long run with significantly lower overhead and full liquidity. Investors should model total costs carefully rather than relying on appreciation alone to justify the investment thesis.

What is a 1031 exchange, and when does it make sense to use one?

A 1031 exchange — named after Section 1031 of the US Tax Code — allows real estate investors to defer capital gains taxes by reinvesting the proceeds from a property sale into a like-kind replacement property within strict timeframes (typically 45 days to identify a replacement and 180 days to close). It's a powerful tool for investors who want to continue building a real estate portfolio without triggering a large tax liability. However, it requires careful planning and is not useful for investors who intend to exit real estate entirely, as the deferral eventually becomes payable upon a non-qualifying sale.