What happened

Shares of mortgage-focused real estate investment trust (REIT) Redwood Trust (RWT 1.29%) rose as much as 11% on Aug 11. That gain, however, was pared in the last hour of trading, with the stock ending the day with a lower, but still notable, gain of around 7.5%. The big driver was an analyst call out by Raymond James.    

So what

First some background. Redwood Trust belongs to a niche of the REIT sector that invests in mortgages and mortgage securities instead of owning physical properties, like more traditional REITs. A key piece of the mortgage REIT model is leverage, generally using the value of a company's mortgage portfolio as collateral for the loans taken on. The problem with this is that when financial markets get volatile, the value of mortgages can decline sharply, leading banks to require additional capital to secure the loans they back. If that capital can't be found, a mortgage REIT could be forced to sell assets to resolve the shortfall, basically at the exact moment when the mortgages are being undervalued by the market. 

Three people standing in front of a house with a for sale sign on the lawn

Image source: Getty Images

This dynamic is basically what played out earlier in 2020 when the COVID-19 pandemic started to spread around the globe. Investors quickly sold mortgage REITs, including Redwood Trust. The stock is down over 50% so far this year, and that's actually a vast improvement from the roughly 80% decline at the worst of the broader bear market that pushed the S&P 500 Index lower by around 30%.

Today's upgrade to strong buy from outperform at Raymond James is largely based on the view that Redwood Trust's book value (which is effectively the value of its mortgage portfolio) is recovering now that financial markets are on more stable footing. Add in Raymond James' expectation for accretive investments in new mortgages, and the broker decided to increase the REIT's price target to $10 per share from $8. Investors were obviously pleased with the news. 

Now what

The problem is that mortgage REITs are not appropriate for most investors because of their unique business model. When things go wrong, they tend to go wrong very fast because of the leverage involved. That said, Redwood Trust isn't a bad REIT, but if you step in here, you'll need to dig in to really understand its approach. And then you'll likely want to monitor it more closely than you would a property-owning REIT.