Water is scarce in the West, making it a valuable commodity and an integral component of rural land ownership. This was clearly demonstrated in the Klamath River Basin during summer 2001.1 As Oregon's population continues to increase, the possibility for similar conflicts in other parts of the state is very real. For attorneys advising financial institutions, debtors, and creditors, it is important to understand that water plays a fundamental role in the value of rural properties.
This article addresses the issues related to the evaluation of water rights on rural properties, and the issues to be aware of when accepting irrigated land or water rights as collateral for a loan. The discussion begins with a cursory review of the legal framework governing the acquisition and use of water in Oregon. It continues by identifying several issues and risks associated with the use of water under this system. Then it briefly touches on valuation considerations, before concluding with recommendations for successfully creating a security interest in water rights and protecting that interest.
Oregon Water Law
Oregon's water laws have evolved considerably since Oregon became a state in 1859. However, the basic foundation is the prior appropriation doctrine, used by all of the western states. Under Oregon's system, a property owner who does not receive water from a community water supply system must have a State-granted legal right to divert and use water.2
The prior appropriation doctrine is founded on the basic premise of priority, often described as "first in time is first in right." This differs from the riparian doctrine used in eastern states, which mandates shared reasonable use of the resource. A prior appropriator has the right to fully satisfy a water right by diverting the full entitlement under that right regardless of stream or aquifer conditions. All later rights or "junior" priorities may begin to divert water only after the senior right is fully satisfied.
To help ameliorate the harsh results of a pure priority system, the prior appropriation doctrine establishes several significant limitations on an appropriator's rights. The first limit is the concept of "beneficial use." An appropriator is only entitled to divert the amount of water actually needed to accomplish the beneficial use for which the water is diverted; any additional diversion is considered "waste." This can limit the rate, volume, or timing of a diversion. Additionally, any water placed to a beneficial use on an appropriator's property becomes appurtenant to that property. Generally, this means the landowner cannot move the water right to other lands or convey the right separately from the underlying land without taking affirmative legal action. Finally, a water right is subject to abandonment or forfeiture for nonuse. In Oregon, nonuse over the five-year statutory period results in a presumption that the right has been forfeited. Abandonment typically requires nonuse together with evidence of intent to permanently relinquish a water right.
Issues and Risks Under the Prior Appropriation System
During the 1990s, the West was the fastest-growing region in the United States. By the year 2000, it was home to fifteen of the top twenty fastest growing counties, and all five of the fastest-growing states. This rapid increase in the number of thirsty mouths and lawns placed unprecedented pressure on the region's already scarce water resources. In addition, during the late 1990s many of the West's streams and rivers were designated as habitat for endangered fish, further constraining the availability of water for all uses other than instream flows. Oregon's water resources are experiencing all of these pressures.
This increasing scarcity has the potential to affect both the value and reliability of water rights used for by rural property owners. If the water supply is truly reliable, the value of the right will climb. However, if the supply is subject to interruption due to insufficient supply, competing demands, or governmental regulation, the value will reflect that decreased reliability. Thus, the risk analysis is subsumed within the valuation analysis.
The water right risk analysis hinges on the questions of availability and reliability. If the water right is not legally or physically available under certain conditions when there is a demand, the utility and value of the rural property is diminished. For properties used in agricultural production, this risk is multiplied if the water shortage occurs at crucial times in the growing or processing season.
There are many factors that can affect the availability or reliability of a water right. Those factors should be accorded varying weight in the risk analysis, depending on the individual circumstances presented by the property in question. Although the specific factors to be considered will vary from case to case, they can be organized into general groups of factors that should always be considered.
Title Issues. Title companies do not insure water rights in Oregon. This reflects the inconsistent manner in which water rights are treated in most real estate transactions. Although the Oregon Water Resources Department maintains ownership records, more often than not, water rights are ignored or simply mentioned as an appurtenance to the real property in the transactional documents. This makes a traditional title search difficult. Nonetheless, a search of county and state records is a prudent step to determine whether there may be any recorded title defects related to water rights such as options, rights of first refusal, licenses, covenants, and prohibitions against sale or transfer. A title search may also uncover liens or encumbrances against the water rights.
Determining the Status of Water Rights. The right to divert water and place it to beneficial use can take on a number of forms. Each has its own related risks. These rights fall into the following general categories:
1) Inchoate Rights. Inchoate rights are known as permit rights.3 They represent a right to begin withdrawing water and placing it to beneficial use. These are not vested property rights. Consequently, these rights should be assigned rather than conveyed by deed. Additionally, they must be "perfected" through beneficial use within a certain amount of time.
2) Vested Rights. These are traditional water rights known as perfected or certificated rights. They are the equivalent of a real property interest.
3) Contract Rights. These rights may arise out of contracts with the United States Bureau of Reclamation or private suppliers. They are usually subject to curtailment or pro-rata reduction during times of shortage or due to government regulation, often without recourse against the supplier. Additionally, such contracts are for fixed terms, raising the risk of nonrenewal upon expiration.
4) Exempt Uses. Oregon law permits certain uses of water in limited amounts for limited purposes without a water right. These so-called "exempt" uses include small domestic wells, livestock water, fire fighting use, and small commercial uses. The exemptions are different for surface water use and ground water use.
When evaluating physical constraints on the availability of water from a particular source, it is important to examine the hydrologic, geographic, geologic, and climatologic factors that influence the source. In addition, artificial influences such as dam operations should be considered as well. These factors combine to produce physical constraints affecting water availability. Those constraints can include water quality, seasonal fluctuations in water levels, susceptibility to drought conditions, over-appropriation, ground water mining (when extraction exceeds recharge), hydrologic connection between surface and ground water, and the availability of storage supplies.
Although water may be physically available from a particular source, it may not be legally available to a landowner. Legal constraints on water use include the terms of the water right (priority, rate and volume limits, place of use, point of diversion, season of use, etc.), contractual terms, water conservation or management regulations, instream flow requirements, and land use restrictions.
Historic Use Concerns
The doctrines of forfeiture and abandonment can extinguish an otherwise valid water right following an extended period of nonuse. Therefore, it is critical to conduct an historic use analysis to verify such nonuse periods have not occurred. Oregon laws require partial forfeiture if some portion of the water right has remained unused for the statutory period. Therefore, an historic use analysis necessarily involves comparing the paper right with the actual use of water on the ground. A careful analysis may also uncover evidence of water spreading, which is the use of water on more acres than permitted under the water right.
The scope of the historic use analysis will likely depend on the value of the obligation to be secured. However, at a minimum, the analysis should include an evaluation of all readily available evidence of water use such as ground photos, aerial photos, diversion records, and pump logs. A more detailed analysis would include interviews of neighboring landowners, soil composition analyses, review of production records, electrical records for irrigation pumps, and similar anecdotal evidence of water use. It is also advisable to obtain a declaration or affidavit from the water right holder that the water has not gone unused for the statutory forfeiture or abandonment period. For some properties, this information will be easy to find and plentiful. For most properties, the information will be more difficult to obtain and may be incomplete. A knowledgeable certified water rights examiner or water rights lawyer should be able to estimate from the outset how difficult and expensive a search will be.
There is a long list of potential outside influences that could affect water availability. Most are unique to a given context and are, therefore, difficult to identify in the abstract. Due to this difficulty, it is important to work with state water officials to identify concerns relevant to the specific property in question. These concerns include any of the following:
- Potential or ongoing litigation regarding the source stream or aquifer.
- Unexercised municipal rights or undeveloped inchoate rights.
- Unadjudicated rights.
- Unquantified Federal reserved rights and tribal rights.
- Endangered Species Act flow or temperature requirements.
- Water quality requirements.
- Dredge and fill permit requirements (pump platforms and other structures in jurisdictional wetlands).
- Hydrologic connectivity determinations between surface and ground water.
- Cost of electricity to operate irrigation pumps.
- Well deepening requirements.
- Changes in state law, regulations, or policy affecting water rights.
Valuation of Irrigated Land and Water Rights
When attempting to appraise irrigated property, it is crucial to consider water rights as a fundamental component of the analysis. The water rights add value to the real estate. They are also crucial to the revenue stream in agricultural enterprises. Additionally, the water rights may have independent value apart from their use on the rural land.
As mentioned above, one of the first components of the analysis is an appraisal of the availability and reliability of the water right for the intended use of the property. This produces a risk factor that can be used to discount the underlying property value in proportion to the level of concern regarding the future availability of water.
In addition, an appraiser should evaluate the availability of the water for transfer to other purposes such as municipal and industrial uses. This analysis should include a legal evaluation of whether the right is subject to transfer and how much water would be available. It should also include an analysis of the financial and engineering feasibility of conveying water from the source to new locations.
The best appraisal method will depend on the circumstances. Traditional appraisal methods used for real property may produce inaccurate results; especially where an appraiser is attempting to value the water rights apart from the land. This difficulty is only magnified by the typical lack of market information for water rights. To compensate for such difficulties, water right appraisers and scholars have developed at least five different methods for appraising water rights and irrigated land. These include market value analysis approach, sales comparison approach, income capitalization approach, analysis of land value differentials, and the development-cost approach.4 Often the best value estimate is derived from a combination of multiple methods.
Creating and Protecting Security Interests in Water Rights
In Oregon, security interests in water rights are generally created and perfected in the same manner as mortgages in land. This treatment has been extended to include an after-acquired property interest in the form of contractual rights to irrigation water. See, e.g., Wayt v. Buerkel, 128 OrApp 222, 975 P.2d 499 (1994). As a general rule, the law presumes that water rights pass with the title to the underlying real estate in any conveyance. However, a seller can sever water rights from the underlying property by express reservation, assignment or conveyance to a third party. This same principle of divisibility would permit a lender to separately encumber the land and water rights. Thus, borrowers and lenders may find added flexibility where they are seeking to collateralize a small loan with something less than the lender's entire land holdings. If the lender is willing, it could accept one or two water rights from the borrower's portfolio as collateral for the loan.
As the pressures on Oregon's water resources continue to mount, and as the value of water rights continues to increase, this type of transaction is more likely to take place. However, there is a risk, because Oregon's law on this topic is relatively undeveloped with respect to other western states.5 One example of an unresolved issue is the question of water right ownership on property within irrigation districts.6 Frequently, the water rights for all lands within the boundaries of an irrigation district are held in the name of the district. However, Oregon law generally considers a water right to be appurtenant to the land on which it is applied. Thus, the question arises as to whether the district or the landowner owns the water right and can pledge it (or subsequently convey it) as collateral for a loan. Likewise, when a creditor initiates foreclosure proceedings against the landowner, a question may arise as to whether the irrigation district must also be named as a party to the action. Until issues such as this are resolved, lenders may be rightly hesitant to accept individual water rights as collateral.
Regardless of whether the collateral consists of land and water rights or just the water rights, there are steps a lender or creditor can take to minimize some of the risks discussed above. Some of the most effective steps include the following:
1) Hire or train the necessary experts. A lender or creditor should have in-house or external personnel who understand state water law, environmental laws, and current legislative and public policy developments likely to affect water rights, and who can evaluate the risks associated with these issues.
2) Review All Available Water Rights Information. Information about the rural property and its water rights will likely be available in a number of forms. The Oregon Water Resources Department and possibly the county clerk's office will have records on individual water rights. Additionally, both the State Watermaster for the area, and surrounding landowners are a valuable source of background information.
- Lenders should compare this information to the loan application for consistency; it may be that a prospective borrower only holds water rights for half of the irrigated acreage being pledged as collateral.
- Determine whether there are other water rights in the area that may affect the borrower's ability to access water. Nearby wells, senior water rights7, and undeveloped inchoate rights all have the potential to impact water availability.
3) Take Necessary Steps to Protect the Collateral. Where irrigated property secures an obligation, affirmative steps should be taken to protect the collateral.
- Lenders should require the borrower to provide evidence that the water rights are being put to full use at least once every five years in order to avoid forfeiture. Such evidence could include photographs, irrigation records or affidavits of a certified water rights examiner.
- If the property lies within the boundaries of an irrigation district, the secured party should put the district on notice that it holds a security interest in the water right. This should help insure that the security holder is notified if the landowner or district takes any action inconsistent with the maintenance of the right.
- A creditor foreclosing on property with appurtenant water rights steps into the shoes of the landowner, subjecting the creditor to any deadlines with regard to water rights on the property. These deadlines include the period allowed for perfection of an inchoate right or transferred right, as well as the statutory forfeiture period for nonuse. In either situation, the creditor must take affirmative steps to protect the water rights.
4) Understand the Potential for Unanticipated Costs and Delays. Transfers, adjudications, and water rights litigation are expensive and time consuming processes. A simple dispute can quickly escalate into complex, multi-party litigation. Frequently, water rights disputes are based more on principle than sound business judgment, resulting in litigation expenses that bear little relation to the underlying property value. Mark Twain understood this when he wrote, "Whisky is for drinkin'; water is for fightin'."
While water rights issues are complex, the associated risks are manageable. A lender or creditor that understands state water law and remains informed on current developments in related legislation, policy, and court decisions is well positioned to protect itself. Even with this minimal knowledge, lenders and creditors can identify issues of concern, and initiate a more detailed risk analysis by their in-house experts or outside consultants.
1The average price of irrigated farmland in the Klamath Basin dropped from $2,200 — 2,800 per acre in Spring 2001 to $150 — $250 per acre in July 2001, after federal reclamation project water was redirected from agriculture to endangered species.
2A limited number of statutory exceptions to this requirement are discussed below.
3Oregon also recognizes water right "Claims", which are rights initiated before the state water code was adopted in 1909. A Claim remains an inchoate right until confirmed by a court in a basin-wide adjudication. Such an adjudication is now underway in the Klamath Basin.
4The comparison of the relative merits of these valuation methods is beyond the scope of this article.
5Various states treat certain water rights as personal property or even certificated securities in the case of mutual ditch company shares (of which there are a few in Oregon). However, the Oregon courts have not yet addressed any cases in which such an argument has been raised.
6Under ORS Chapter 545, irrigation districts are quasi-municipal entities, vested with many local government powers, including condemnation. Oregon law also recognizes several other special districts with statutory authority to provide irrigation water to rural properties. For the purposes of this article, the term "irrigation district" is also intended to refer to other special districts supplying irrigation water.
7In eastern Oregon, it is not uncommon for a water right with an 1880 priority date to be curtailed in mid-summer during a dry year.