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3 Things Robinhood Traders Should Consider Before Investing in Mortgage REITS

Online broker Robinhood is changing the way people invest, in both good and worrisome ways. Some troubling signs show up in the company's list of the 100 most popular stocks, which changes regularly and recently included mortgage real estate investment trusts (mREITs) like MFA Financial (NYSE: MFA), New Residential Investment (NYSE: NRZ), and New York Mortgage Trust (NASDAQ: NYMT).

These are not your typical real estate companies, and they need to be treated with caution. Here are three things Robinhood traders should consider before stepping into this niche area of the REIT sector.

1. Investments, not property

Real estate investment trusts are specially designed corporate entities meant to pass income on to their shareholders. They pay out 90% of their taxable income, and in exchange, they avoid corporate-level taxation. Shareholders treat the dividends as regular income.

Image source: Getty Images

Most REITs own physical properties, like apartments, offices, and hospitals, among many others. The rent generated from these assets underpins a REIT's dividend-paying ability, and the value of the properties themselves underpin a REIT's valuation. Property-owning REITs are generally simple to understand, but the standards and guidelines mREITs operate under throw almost all of that out the window.

Mortgage REITs, as the name implies, own collections of mortgages. These are nothing more than pieces of paper that say a borrower will repay a loan, with interest, at regular intervals. Usually, these loans are packaged into a group, known as a collateralized loan obligation (CLO), so the entire portfolio can be traded as a single unit.

But the key here is that mREITs own financial assets, not physical assets. The value of CLOs can change materially and rapidly based on investor sentiment. While something similar can be said of a physical property, the volatility involved is vastly different. This is the basis of the problem with mREITs, but not the complete picture.

2. Leverage is tricky

The core model in the mortgage REIT space is to use leverage to buy mortgages. The biggest problem is that, usually, the collateral for the debt an mREIT takes on is the portfolio of mortgages it owns. It's a similar set up to a margin loan, in which the value of your portfolio dictates how much debt you can use. If the value of your portfolio falls, the amount you can borrow declines. The same is generally true for mREITs, which we already know own mortgage securities that can rapidly change in value based on investor sentiment.

If your portfolio were to decline below the value of your margin loan, your broker would ask you to come up with more cash to solve the discrepancy. If you didn't have the cash, either you'd have to sell things or the broker would do it for you. The same is basically true for mREITs that have taken out loans based on the value of their mortgage portfolios. Here's the problem: When things are bad and you get a margin call, you don't sell what you want to sell -- you sell what you can quickly sell. That depresses values in the mortgage space and could leave the mortgage REIT owning lower-quality loans.

What happened to MFA Financial this year is a perfect example of how bad things can get. When COVID-19 hit, the value of its securities fell, forcing it to ask lenders to hold off on enforcing their legal rights, specifically including their right to sell collateral to enforce margin calls. MFA suspended its dividend in an effort to preserve cash, which is a terrible sign for any company -- let alone a REIT, which is specifically designed to pass income on to investors. Dividend cuts are usually associated with steep price declines in the REIT space.

3. When things go wrong, they go wrong fast

What happened to New York Mortgage Trust wasn't quite as bad a story, but it cut its dividend from $0.20 per share per quarter to just $0.05 per share. As did New Residential Investment, which took its dividend from $0.50 per share per quarter to $0.05 per share. Notably, New Residential, which is even more complex than your typical mortgage REIT, actively chose to sell roughly 70% of its mortgage investments in a single quarter to avoid margin call risk. These are not your run-of-the-mill investments, and they need to be treated with extreme caution. Think of them like swimming in the deep end of a pool.

MFA data by YCharts

The chart above offers clear proof of just how quickly things can change for a mortgage REIT. Notice how much deeper the sell-off was for this trio of mortgage REITs than in the broader REIT space, as measured by Vanguard Real Estate ETF. Some short-term investors see volatility as an opportunity to make trades, but when that volatility is all to the downside and happens quickly, it is often just a way to lose a lot of money at a rapid clip. If you've never lived through a downturn like the one shown above, the speed at which you can lose wealth with heavily leveraged investments can be paralyzing. That's doubly true if you are using leverage via a margin loan.

This type of downdraft, however, has been seen before, for instance during the 2008-09 recession, when mortgage REITs faced similar pressures. Put simply, today's troubles aren't a unique event -- they are really just a normal part of the mREIT space. And the pain can spread very, very quickly.

That's enough, but it's not all

These three key points should be more than sufficient to ward most investors off of buying mortgage REITs. But that isn't the entire list of issues -- the ability of a mortgage borrower to pay is also often reduced during a recession (like the one that started in February) and that, too, can impact the value of mortgages and start a downward spiral all on its own.

Mortgage REITs are not easy to understand and need careful monitoring. If you aren't willing or able to do the legwork here, you're probably better off avoiding this niche of the REIT sector.

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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Vanguard REIT ETF. The Motley Fool has a disclosure policy.


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