How honest should one be with their students when talking about the realities of academia?
I am a student so this is coming from a student's perspective.

I think you should be honest with them regarding what going into graduate school entails. For my case, none of the professors I initially talked to encouraged me to go to graduate school, and for good reason. Each of them stated what the cons were to going to graduate school and how the academic job market is now much more competitive than when they were a fresh Ph.D. graduate. Was this discouraging at first? Yes. However, it also helped me in cognitively organizing why I wanted to go to graduate school and I was able to set a firm goal and stick with it.

Those professors often told me that the reason why they would encourage students to take a gap year and think long and hard about the next step is precisely because students often make the assumption that Ph.D. is the obvious 'next step' when it very well might be the exact opposite of what they wanted. 

Coming from a student's perspective, I appreciate honesty from professors because it helps me to realize the reality of going into graduate school and potentially what kind of sacrifices I need to make (e.g. a good chunk of my youth, vacation time, etc.). However, I never found it appealing when a professor, who I aspire to be like, tells me that I'm not good enough to ever do what they do without additional feedback.

In my case, when I first approached those professors about my plans to go into Ph.D. to become a professor, my main advisor looked at my records and told me what to expect, where I currently stand, and what I can do to improve should I wish to stay on that path. I think the last bit is the most important piece of feedback I received. The first two parts can help me in deciding if this is the correct next step for me, but the third part is what will help me achieve that step despite the challenges.

So all in all, if I were one of your students, I would appreciate honest commentary on my goals as well as the additional feedback on what I can do to improve so that the choice of pursuing a Ph.D. is still ultimately my decision. This also helps students to develop and mature, I think.