An Explanation of Real Estate Investment Returns

09 Jan 2026

The goal of this writeup is to explain the four sources of return for real estate investments. These four sources feature prominently on the Proforma.

My knowledge of real estate has primarily come from my father, getting my real estate license, working in corporate finance for a homebuilder, and Real Estate Investing for Dummies. I am starting to do my own real estate investing, but I am not that experienced yet.

Real Estate is defined by the State of South Carolina as:

S.C. Code Regs. § 117-1700.1: "For the purpose of classifying property for taxation, land, buildings and items of property devoted primarily to the general use of the land and buildings, and all other property which according to custom has been considered to be real property, are defined as real property."

That is blah-blah-blah for land and the buildings on that land. Real estate is, at-present, the largest asset class in the world by market cap (total value of the market). Gemini was able to build this table for me to show just how big real estate is relative to other asset classes in the US. This was done in January 2026.

Asset Class Market Capitalization (January 2026 Estimates)

In a prior article, we went through the sources of return of stocks, Intro to Investing. Returns for stocks come from either price appreciation or dividends, i.e. the value of the company goes up or they write you a check for your share of returns. Real estate has two sources that will function similarly to price appreciation and dividends, but they also have tax advantages and are often leveraged (i.e. debt is used to purchase real estate).

The four sources of Real estate returns are:

1. Cash Flow: Rental income that exceeds expenses
2. Appreciation: Growth in the value of the property from broad market appreciation or improvements made (sweat equity)
3. Debt Reduction: Reduced debt balance, hopefully paid with excess rental income
4. Tax Advantages: Reduced tax liability from depreciation and interest expense deductions

So let's run through these one-by-one.

Cash Flow is when rental income exceeds expenses. Expenses are going to include the mortgage payment and operating expenses, like property taxes, insurance, and maintenance. This is analogous to dividends for stocks. You will often hear real estate guys say "this property cash flows" or "cash flow positive". That is what you want if you are looking for passive income.

Appreciation is when the property is sold for more than it was purchased for. We break this into two components: market appreciation and sweat equity. These returns are not liquid until the property is sold. Market appreciation can be thought of as inflation; you can expect properties to go up over time, but it is also driven by supply and demand for the area and for that property. Some places see faster appreciation than others for a time. This is analogous to price appreciation for stocks.

Sweat equity is when an improvement you make on the property increases the value of the property more than it cost to make the improvement. House flippers make their money from this component. Sometimes minor improvements like repainting or landscaping can increase the value of a property by significantly more than it cost to make the improvement. This happens because buyers interested in living in a house likely don't want to deal with any issues. House flippers can buy the property for less because of the lack of demand, clean it up, and unlock the value of the property.

Debt Reduction results from paying down the debt over time. When cash flow is positive, that means that the income from tenants is enough to pay the mortgage expenses. This means that the tenants are paying for the debt for you, and you get to keep the principal that is paid down. These returns are not liquid until the property is sold.

Finally, Tax Advantages. I am not a tax professional, but I can explain in principle how Depreciation and Interest Expense deductions work. These returns are tax savings, not cash income. Depreciation is a "non-cash expense" for wear and tear on the property. What that means is that property owners can claim an expense, reducing taxable income, for the value of the property over time. In the proforma, I use 27.5 years as the "useful life" of the property. Again, I am not a tax professional, but this is what I understand as being the regular useful life of real estate property according to the tax code. So, in principle, the value of the property is divided by 27.5, and that amount is deducted from your taxable income. A technical note on this is that it lowers your basis, making depreciation a tax deferral, not a tax shield.

The Interest Expense deduction is also called the "Debt Tax Shield". Interest paid on a mortgage is tax deductible, meaning you can subtract it from your taxable income. There are some caveats to when you can do this, but from my understanding, interest can be deducted on your personal home and investment properties, but not hunting land or other recreational properties.

I think some people think they are getting more out of tax deductions than they really are. Note that these deductions reduced your taxable income. The actual return resulting from the deductions is going to be these expenses times your marginal tax rate, so if you take $5,000 in depreciation, paid $5,000 in interest in a year, and your marginal tax rate is 25%, your savings on taxes are $2,500 total. I am glad to save this, and it is a major advantage of Real estate investing, but you hear lots of "Oh, it's tax deductible!" to justify spending. It makes me think people don't really understand how this works.

A key assumption of the proforma is that the property is held and operated for five years, and then sold. This allows us to calculate the expected total return on the property and see how each source of return contributes. I am honestly quite proud of this view! You may or may not actually sell after five years, but it makes for a straightforward analysis. I encourage you to play with the proforma at some point outside of looking at a specific property to see how assumptions affect the sources of return. The proforma also can be helpful for defining a "target" type of property if you are targeting a specific source of return, probably cash flow.

In conclusion, Real estate offers a few additional sources of return that are not available for most stock purchases. Returns can come from cash flow and appreciation, similar to dividends and price appreciation. In addition, real estate is often bought with debt, resulting in some returns from debt reduction, and real estate offers tax advantages. The Proforma is a helpful tool to analyze a property through the lens of these sources of return, and it is also a great educational tool to understand real estate investing.