June 9, 2015

Water Rights Considerations in Agricultural Lending



MAY 2015

Water is a scarce and valuable commodity. It is also an integral component of agricultural land ownership. A lender must be able to evaluate issues related to both the risk and value of the collateral it relies upon to secure a loan. As a result, water availability must be considered by financial institutions involved in agricultural lending.

Prior Appropriation Doctrine. Western water rights are allocated according to the prior appropriation doctrine. The doctrine is based on temporal priority, often described as “first in time is first in right.” This means the older or more “senior” water rights must be fully satisfied before the younger or more “junior” water rights can receive water. Priority is, therefore, one of the most important considerations in a water rights evaluation process.


Risk Analysis. Western water supplies are under ever-increasing pressure from population growth, a complex regulatory environment, and drought. These factors can lead to scarcity in supply that has the potential to affect both the value and reliability of water rights used for agricultural purposes. 


If the water supply is reliable, the value of the right will climb. However, if the supply is subject to interruption due to insufficient supply, competing demands based on priority, or state or federal regulations, the value of the water right decreases.  As a result, the water right risk analysis hinges on the questions of availability and reliability. If the water right is not legally or physically available when it is needed, it puts an agricultural business at risk. This risk is multiplied if the water shortage occurs at crucial times in the growing or processing season.

Other factors that can affect the availability or reliability of a water right may also exist. Although they will vary from case to case, these may include: 1) legal title issues; 2) the legal status of the water right; 3) physical constraints; 4) legal constraints; and 5) historic use concerns (which raises the potential for forfeiture by operation of law).

Recommendations to Minimize Risk. Risk is inherent to any water-dependent agricultural enterprise. There are several things a lender can do to minimize exposure such as: 1) hiring or training the necessary experts; 2) understanding how water supply influences the borrower’s operations; 3) taking necessary steps to protect the water right as collateral; and 4) understanding the potential for unanticipated costs and delays.

Valuation of Irrigated Land and Water Rights. When attempting to appraise irrigated agricultural lands, it is crucial to consider water rights as a fundamental component of the analysis. Water rights add value to 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 agricultural land.


The Bottom Line. Water rights issues are complex, but the associated risks are manageable. A lender that understands state water law and remains informed on current developments in related legislation, policy, and court decisions is well positioned to protect itself. 

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