What happened

Today's another incredible day on Wall Street. Stronger-than-expected jobs data has investors convinced the economy is on the mend from the coronavirus lockdown. The SPDR S&P 500 ETF Trust (NYSEMKT:SPY) was up 2.8% at 1:04 p.m. EDT on Friday, with stocks in just about every sector climbing. 

One of the biggest group of gainers is mREITs, real estate investment trusts that focus on real estate debt. Six of the biggest are up between 5.1% and a massive 41% today: 

mREIT  Price change on June 5*
MFA Financial (NYSE:MFA) 41.4%
Invesco Mortgage Capital (NYSE:IVR) 30.1%
New York Mortgage Trust (NASDAQ:NYMT) 18%
Two Harbors Investment (NYSE:TWO) 5.1%
Granite Point Mortgage Trust (NYSE:GPMT) 21.9%
Annaly Capital Management (NYSE:NLY) 5.7%

*As of 1:04 p.m. EDT. Source: YCharts. 

So what

A recovering economy and improving jobs data are good indicators for mortgage REITs. These companies make money from the interest paid by the mortgages and real estate debt that they own, but they also use loads of debt to fund those investments, making a profit on the spread between the interest rates they pay for the debt they take on and the interest yields they earn on the mortgages they invest in. 

Screen capture of a stock price chart.

Image source: Getty Images.

Since the coronavirus pandemic shut down the economy, more than 20 million Americans have lost their jobs and are still out of work. The risks of mREITs was increased substantially, since the number of people unable to pay mortgages has gone up substantially.

Even with abatements for many of those to help them avoid foreclosure, the pressure for mREITs has been very high; they haven't, as a group, been able to get the same abatements for the debt they've taken on to buy the mortgages they own. That's why the majority of mREIT stocks are still down substantially, even though the broader market has bounced back:

MFA Chart

MFA data by YCharts.

Today's jobs data is alleviating some of the fears that many mREITS will struggle severely in the months ahead. The U.S. Department of Labor report said the unemployment rate fell to 13.3% in May, a terribly high level by any objective measure, but a sharp improvement from almost 15% in April, as employers added a massive 2.5 million jobs, mostly service and retail jobs that were lost during the stay-at-home orders that closed down thousands of businesses. 

Now what

The jobs report is a real positive, and a signal that the economy really could bounce back quickly once the COVID-19 pandemic ebbs. Consumers are starting to spend again where stores and other businesses open back up. 

Yet within this positive signal, investors should continue to wade in carefully. The COVID-19 story seems to have fallen out of the narrative this week, but the risk of a second wave is very real. In some places that opened up early, cases are starting to rise again. There still are no effective medical treatments, and vaccine development efforts are not expected to yield meaningful results before next year. 

As for mREITs, let's remember that they are still down by about half as a category for reason: The risks they face are still there. Over 20 million Americans are still out of work, and millions more still face reduced hours and wages. Even a small reduction in the number of people paying their mortgages could wreak havoc on the cash flows for many of these companies because of the amount of debt they rely on to underpin their investment strategy. 

Sure, the risks are mostly reflected in valuations; most trade well below book value:

MFA Debt to Assets (Quarterly) Chart

MFA Debt to Assets (Quarterly) data by YCharts.

But that doesn't mean they can only go up from here. Many mREITs will burn through their cash reserves and could face limited access to additional liquidity.

The economy is still in rough shape, and the chances of a prolonged downturn make this sector of real estate risky, simply because so many companies rely so heavily on leverage. In a healthy economy, the leverage can work well to make them excellent dividend stocks, but in a recession, it makes things a lot more difficult. 

Invest according to your ability to experience permanent losses at worst, and ride out substantial volatility at best.