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1 Big Risk Factor Mortgage REIT Investors Should Know

When it comes to risks and mortgage real estate investment trusts (REITs), many investors know that these investments are susceptible to interest rate fluctuations. But there's another risk factor to be aware of, and it caused mortgage REITs to plunge at the start of the COVID-19 pandemic. In this Fool Live clip, recorded on Dec. 10, contributor Matt Frankel, CFP®, discusses one factor that could cause mortgage REITs to plunge during uncertain times.

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Matt Frankel: It's not uncommon for mortgage REITs to cut their dividends when rates rise and for them to underperform the market, which we saw Annaly (NYSE: NLY) did the last time the Fed was raising rates. That was Annaly's dividend history during the last rate-hike cycle.

Risk No. 2, and this is one that's often overlooked by investors, is asset valuations. These companies are not investing in mortgages directly. Annaly is not loaning money to people; they're buying mortgage securities on the open market. These securities change in value over time just like any other type of security, like a stock or a bond. Interest rates are only one potential catalyst that can cause the value of mortgage securities to decline.

Perceived default risk is one big one. If you think someone's going to stop paying their mortgage, that mortgage becomes worth a lot less money, right? Makes sense. Think of what happened at the beginning of the COVID pandemic in March before the CARES Act, before any of the relief was passed, what did everyone think was going to happen as people couldn't work anymore but still had to pay their mortgages? It was expected that people were going to start defaulting in large numbers.

This caused mortgage valuations to plummet and led to a chain reaction. I don't know if you're familiar with the term "margin call." But because these companies use a lot of borrowed money, they were getting hit with margin calls left and right. They were forced to sell assets at fire-sale prices, and here is a chart of four of my favorite mortgage REITs in the beginning of the COVID pandemic. This is January through April of 2020. I can get it on the screen, there we go. The purple bar is Annaly. This is in a four-month period in early 2020 because of this perceived default risk in the market.

Annaly stock plummeted by 57% over that four-month period. It has since rebounded pretty nicely. It's not quite where it was. Broadmark (NYSE: BRMK) actually fared a little bit better, down only 47% that time, and I'll explain why they fared better when we get to the specifics of that company. Another one that's one of my favorites and I'm going to discuss, Blackstone Mortgage Trust (NYSE: BXMT) declined by 59% in that four-month period. These have rebounded since then, but did not fully recover because they were forced to get rid of their income-producing assets at a fire-sale valuation.

If I update this chart to the beginning of 2020 till now, you can see that all four of these mortgage REITs are still down from where they started in 2020. The reason is they generally got hit with margin calls, had to unload assets. Because of this, their asset values plunged and it was like a perceived risk of default. Everyone thought no one is going to be able to pay their bills, and then the government swooped in with the CARES Act and that's where this sharp rebound happened in early 2020. But it's been a steady climb, but not out of the woods, it's kind of tapered off. That's another thing. Not that another COVID pandemic's going to happen again anytime soon. Let's knock on wood, I hope not. But this is definitely a risk people need to know.

Matthew Frankel, CFP® has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.


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