The past couple of months have been downright awful for mortgage real estate investment trusts (REITs). Even agency REITs, which invest almost entirely in mortgage-backed securities guaranteed by the U.S. government, have seen decreases in book value and deleveraging.

A few of the non-agency REITs have seen almost their entire portfolios sold to meet margin calls. The agency REITs, which invest in mortgage-backed securities insured by the U.S. government, have performed better and seem poised to exit the crisis of March and April.

Is the mortgage REIT an investment space that's safe enough to reenter? 

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The first quarter was extremely challenging

Annaly Capital Management (NYSE:NLY) is one such mortgage REIT and recently reported earnings. From that report, it was clear that the first quarter was indeed difficult. Book value per share fell from $9.66 at the end of 2019 to $7.50 on March 31, a decline of 22%.

While the company did mention in its April 7 company update that it has been able to meet its margin calls, it's clear the company aggressively reduced its exposure. Assets fell from $130.3 billion to $96.9 billion. Leverage (the ratio of debt to assets) fell from 7.2 to 6.8. Equity fell from $15.8 billion to $12.7 billion. Cash increased from $1.8 billion to $2.8 billion. Net interest margins collapsed from 1.49% to 0.18%.

CEO David Finkelstein described the quarter:

In light of extreme volatility, Annaly performed well through one of the most challenging and unique operating environments in our Company's history. The breadth and flexibility in our investments and financing positioned us to successfully navigate the market uncertainty and we continue to benefit from the size of our capital base and strength of our business model. We took significant, measured steps to fortify our balance sheet and liquidity to position ourselves for the remainder of the year. While we continue to be cautious, we are encouraged by the meaningful tailwinds in the mortgage market and are poised to take advantage of upcoming investment opportunities.

Forbearance creates a tailwind for Agency Mortgage-Backed Securities

Going forward, the agency mortgage space looks to be attractive because the pain in the mortgage market has translated into pain for mortgage originators. The federal CARES Act has required mortgage servicers to grant forbearance to anyone who asks for it, no questions asked.

Forbearance means the borrower can elect to skip paying their mortgage for up to a year. They will have to pay the money back, but it gives them breathing room if they, say, lost their job due to COVID-19.

This law has wreaked havoc in the mortgage origination sector. The end result has been a massive tightening of mortgage credit. Loans that can't be guaranteed by the government aren't getting made. Even loans that can be guaranteed by the government are being restricted. High loan balances, cash-out refinancings, and FHA loans are difficult to find right now. 

How does this benefit mortgage REITs such as Annaly? It lowers the likelihood that borrowers can take advantage of the current low rate environment, which means Annaly's mortgage-backed securities will retain their value for longer. That extra time is worth money, which will be reflected in the prices of mortgage-backed securities.

Credit risk

While Annaly is primarily an agency REIT, it does have some credit exposure. The company's $2.6 billion commercial real estate portfolio consists largely of senior debt, and its exposure is mainly in multifamily and office property. The net lease properties are "necessity-based" anchored -- typically grocery stores and healthcare. The $2.2 billion middle-market lending portfolio is concentrated in defensive and non-cyclical businesses where Annaly is a senior secured lender with "top tier" equity sponsors. Finally, Annaly has a $2.6 billion non-agency residential mortgage portfolio.

Unless the COVID-19 crisis ends soon, there will probably be increased credit losses in these portfolios. Note that Annaly took a $99 million provision for expected loan losses in the first quarter. 

The dividend is not a sure thing

Annaly decided to pay the $0.25 per share dividend it declared in March. Most mortgage REITs have cut their dividends already, so investors shouldn't count on receiving that dividend going forward. Competitor AGNC Investment (NASDAQ:AGNC) cut its dividend by 25%, and it is almost 100% agency. So, a dividend cut is more likely than not.

Annaly is trading at a 15% discount to book value and has $6.9 billion in cash and unencumbered assets to deploy as opportunities present themselves. The negative catalyst going forward would be a dividend cut, but the stock's implied dividend yield of 16% is telling you that a cut is likely priced in.

Is Annaly a buy, here? For long-term investors, the current discount to book value provides a decent tailwind, along with a mortgage-REIT level of dividend yield, whatever it turns out to be. That said, investors need to brace for the possibility of a dividend cut, and that might be the right entry point. AGNC Investment is the better buy at the moment, in my opinion, but the risk-reward ratio for both stocks is favorable now.