Capital Spending's Split Personality

Companies aren't building, but they're buying equipment

What's up with Corporate America? Propelled by a surge in consumer spending, the nation's economy grew at a rate of 3.1% in the third quarter. But for now, the long-awaited turn in capital spending still appears to be on hold. In its third-quarter report on gross domestic product, the government said that capital investment remained essentially flat, inching up just 0.6%. The question is more than academic: The Bush Administration--not to mention economists throughout the business community and on Wall Street--is increasingly worried that the recovery will lose steam without a sustained boost in business spending on new facilities and gear.

Turns out, though, that things aren't as gloomy as they appear. When it comes to technology, machine tools, and other long-lasting equipment, companies finally are starting to loosen the purse strings. Dig into the Commerce Dept.'s Oct. 31 report on the GDP and you'll see that third-quarter capital outlays on equipment and software--which account for roughly 80% of capital spending--increased 6.5% over the second quarter. That's double the 3.3% increase the second quarter turned in over the first. After an 18-month lull in which those sequential growth rates dropped quarter after quarter, companies finally have begun to spend a bit more on computers and other productivity-boosting tools.

So what, then, explains the flat overall growth in capital spending? The weakness can all be traced to the little-noticed but almost unprecedented free fall in spending on nonresidential construction. Private-sector investment in new factories, warehouses, offices, and other commercial buildings plunged 16% in the third quarter from the second. That's on top of a double-digit drop in the first half. All told, business investment in fixed assets has fallen by nearly a third from its peak of $220 billion two years ago, to an annualized rate of $160 billion today.

Moreover, real estate execs and economists foresee no turnaround until next year at the earliest. McGraw-Hill Construction (MHP ), which like BusinessWeek is owned by The McGraw-Hill Companies, figures office construction, for example, will drop another 8% in 2003 after a 29% plunge this year. Adds Kenneth D. Simonson, chief economist for the Associated General Contractors of America: "It could be a long time before companies call in the architects and engineers for new space."

It's routine, of course, in a weak economy for construction to slump and vacancies to soar. Vacancy rates in the top 10 U.S. office markets have jumped to 16.1% from 8.5% two years ago, according to real estate tracker Torto Wheaton Research. What's new is the soaring vacancy rate for industrial properties, which has risen to an estimated 12%. That's double the rate immediately following the 1990-91 recession.

Cyclical factors explain part of that jump. The dot-com bust and telecom rout helped jack up vacancy rates: Developers went into a frenzy building for these tenants through 2000, only to have vacant offices now. "There's just no need for new plants," says Hamid R. Moghadam, chairman and CEO of industrial real estate firm AMB Property Corp. "We are not at the trough of the cycle yet."

But long-term structural changes in the economy, as much as the cyclical slowdown, appear to be at work. As manufacturers rely increasingly on labor in low-wage nations such as Mexico and China, demand for U.S. factory space is weakening. In addition, businesses are intensifying their push toward just-in-time inventories, which means the U.S. needs fewer warehouses.

The construction collapse isn't necessarily bad news for the economy. Companies that are spending little on structures have been able to redirect more of their limited capital budgets to info tech and other new equipment that can quickly enhance productivity, notes Richard B. Berner, chief U.S. economist for Morgan Stanley. True, the quarter-to-quarter gains this year are a far cry from hikes of 18% to 20% in early 2000. But Berner and others believe capital spending will keep rising because, with high-tech prices falling, it's often cheaper to buy new stuff than repair the old. Instead of constructing new plants or trophy towers, companies are quietly reallocating scarce dollars to things that matter most.

By Michael Arndt in Chicago

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