What happened

Shares of mortgage real estate investment trust (REIT) Redwood Trust (NYSE:RWT) fell 19% in April, according to data from S&P Global Market Intelligence. That was a disastrous showing when you consider that the S&P 500 index was up 13% and the average REIT, as measured by Vanguard Real Estate ETF, advanced 9%. However, when you step back and look at the big picture here, the poor showing isn't surprising. 

So what

Redwood Trust doesn't own properties; it owns a portfolio of mortgages. Moreover, the REIT uses debt to leverage its buying power. Redwood Trust makes the difference between its borrowing costs and the interest it earns on its mortgages. That usually leads to large dividend payouts to shareholders, which is the primary attraction here. 

A man holding his head with a candlestick chart heading lower behind him

Image source: Getty Images.

However, when economic conditions deteriorate, things can quickly get difficult for mortgage REITs. The ability for these REITs to borrow is usually based on the value of the mortgages they own, which are used as collateral. When financial markets are volatile, the value of those mortgages can fall materially, often over a very short period of time. When that happens lenders ask for more money to secure their loans (this is known as a margin call). That puts incredible pressure on mortgage REITs, which may or may not have access to the cash they need to satisfy these demands. This is exactly what has happened this year as COVID-19 has upended normal economic life the world over.

So far, Redwood Trust appears to be handling the hit well, reporting in late March that it had met all of its margin calls. However, just a few days after making that announcement, the REIT told investors that it was "delaying" its first-quarter dividend by three months or so. And while financial markets have begun to stabilize, investors are clearly expecting the difficult times to continue for Redwood Trust. That's completely reasonable, with a dividend cut highly likely at some point in the near future.   

Now what

Mortgage REITs like Redwood Trust are most appropriate for aggressive investors when times are good because of their use of leverage. When times get tough, like they are today, even aggressive investors should probably be avoiding these companies. April's decline was just a function of Wall Street's ongoing concerns about mortgage REITs. In fact, through the first four months of 2020, Redwood Trust's stock lost 75% of its value. And, frankly, the REIT still isn't out of the woods just yet. Until the impact of COVID-19 on financial markets is better contained, most investors should be on the sidelines here.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.