Water Rights Issues in Agricultural Lending

Introduction

One-half of the land in the United States receives insufficient precipitation to sustain crops without irrigation. The line of demarcation is the 100th meridian — a climatological boundary that cuts through the center of the Dakotas, Nebraska, Kansas, Oklahoma, and Texas, thus dividing the country into west and east; dry and wet. This line is also a philosophical boundary between the riparian and prior appropriation doctrines of water allocation.

Water is scarce in the West, making it is a valuable commodity and an integral component of agricultural land ownership. Without water to irrigate, process, or package agricultural products, most Western agricultural enterprises would quickly grind to a halt. This was graphically demonstrated in the Pacific Northwest's Klamath River Basin during summer 2001.¹ Because water plays such a fundamental role in the viability of such enterprises, it must be considered by financial institutions involved in agricultural lending.

Like most lending decisions, an agricultural loan application requires a lender to evaluate both the risk of default and the value of the collateral needed to secure the loan. In the case of agricultural loans secured by the underlying property, a lender is frequently looking at the same set of assets in both evaluations. Water rights are one of the most important but frequently overlooked assets to be considered in this analysis.

This article is intended to acquaint the reader with the issues related to the evaluation of agricultural water rights. The discussion begins with a cursory review of the legal framework governing the acquisition and use of water in the West. 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 minimizing risk in lending decisions.

The Evolution of Western Water Law

Historical Roots

Before the western states were carved out of the frontier, the United States government had sole control and ownership of nearly all the western territory, including the land, minerals, forests, and water. To encourage western settlement and promote development of irrigated agriculture, Congress passed the Desert Land Act of 1877. This Act allowed settlers to settle lands formerly part of the public domain on the condition that they "reclaimed" the lands through irrigation. However, the settlers' federal land patents did not include water rights. Instead, the non-navigable waters were reserved for the use of the public under the laws of the individual states. Consequently, those states were free to adopt either the riparian or prior appropriation doctrines as the basis for their water laws.

Riparianism or Prior Appropriation?

When the English settlers arrived in the New World, they brought the English common law with them. This included the "riparian doctrine," relating to a landowner's use of water. The riparian doctrine gives waterfront landowners the right to make reasonable use of a water source so long as it does not unreasonably interfere with the legitimate uses of other riparian owners.

This doctrine works reasonably well in wet climates, where there is sufficient water to satisfy water users in all but the driest years. However, as the gold miners of California quickly learned in the mid-1800s, the riparian doctrine does not adapt well to arid western climates, where streams often run dry by mid-July.

Thus, the miners developed a system roughly based on the mining claim process. Under this system, the first person to divert water (stake a claim) from a stream had a full and unencumbered right to the use of that water to the exclusion of later appropriators. It is this doctrine of "prior appropriation" that was eventually adopted, at least in part, by all of the western states.

Prior Appropriation Doctrine

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, which mandates shared reasonable use of the resource. A prior appropriator, by contrast, 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 most western states. In states recognizing forfeiture, nonuse over the statutory period (usually 5 to 10 years) will result in a presumption that the right has been forfeited. Abandonment typically requires nonuse together with evidence of intent to permanently relinquish a water right.

Modern Day State Water Laws

Although the western states have all adopted some form of the prior appropriation system, they have done so to varying degrees. In fact, certain states along the 100th meridian and the Pacific Coast have systems that integrate riparian rights to a limited degree. This situation is further complicated by the fact that surface water and ground water are often treated inconsistently by state law. As a result, it is impossible to discuss the intricacies of each state's regulatory system in an article of general application such as this. Instead, the assessment below highlights potential issues and risks common to all prior appropriation states.

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 is placing 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.

This increasing scarcity has the potential to affect both the value and reliability of water rights used for agricultural purposes.² 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 federal regulation, the value will reflect that decreased reliability. Thus, the risk analysis is subsumed within the valuation analysis.

Risk 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, 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.

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 prospective borrower. 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. Traditionally, title companies have declined to write title insurance on water rights. This reflects the inconsistent manner in which water rights are treated in most real estate transactions. In some states, water rights transactions must be recorded with the county clerk and recorder's office. In other states, the state water resources agency may maintain ownership records. More often than not, however, 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 usually known as conditional or permit rights. They represent a right to begin withdrawing water and placing it to beneficial use. These are not vested property rights. Consequently, these rights may need to be assigned rather than conveyed by deed. Additionally, they will generally need to 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 in most jurisdictions.
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 under certain circumstances, often without recourse against the supplier. Additionally, such contracts are for fixed terms, raising the risk of nonrenewal upon expiration.
4. Temporary Rights. Most states allow temporary uses of water under an expedited appropriation process. These rights are only available for a few growing seasons at most, and are usually subject to numerous conditions of use.
5. Exempt Uses. Certain uses of water in limited amounts for limited purposes may be allowed under state law without first acquiring a water right. These so-called "exempt" uses generally include small domestic wells, livestock water, fire fighting use, and small commercial uses. The exemptions are generally different for surface water use and ground water use. Some states administer the exempt uses as part of the priority system, while others do not.

Physical Constraints

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.

Legal Constraints

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, etc.), contractual terms, water conservation or management regulations, land use restrictions, and the public trust doctrine.

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 that lenders conduct an historic use analysis to verify such nonuse periods have not occurred. Many state 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 loan. 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. More detailed analyses 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.

Latent Problems

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, lenders should work with state water officials to identify concerns relevant to their geographic area of operations and to determine their potential scope and impact. 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 agricultural lands, 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 agricultural 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.³ Often the best value estimate is derived from a combination of multiple methods.

Recommendations for Risk Minimization

If these risks are inherent to any water-dependent agricultural enterprise, what can a lender do to minimize exposure?

1. Hire or train the necessary experts. A lender must 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 an applicant's water rights will likely be available in a number of forms. The state water resources agency files and possibly county clerk and recorder's offices may have records on individual water rights. Additionally, the state's field representatives and surrounding landowners are a valuable source of background information.
   • Compare this information to the loan application for consistency; it may be that an applicant 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 rights⁴, and undeveloped inchoate rights all have the potential to impact water availability.
   • Consider requiring loan applicants to provide much of this information as part of an application packet.
3. Know Your Borrower's Operation. Lenders must determine the extent to which a borrower's operation relies on the availability of water. This is true for farmers as well as processors, packers, and other related enterprises. Drought or other constraints on water availability can directly or indirectly affect a lender's entire portfolio of agricultural borrowers.
4. Take Necessary Steps to Protect the Collateral. Where irrigated property secures a loan, there are two major considerations related to the protection of the collateral. First, in many jurisdictions, real property and water rights are treated as separate property interests for the purpose of perfecting a security interest. Depending on the jurisdiction and the status of the water right, the water right may be treated as personal property or possibly even a security in the case of the mutual ditch company shares. Second, when a lender forecloses on any property with appurtenant water rights, it steps into the shoes of the landowner, subjecting it 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, a lender must take affirmative steps to protect the water rights.
5. 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 well when he coined the well-known western maxim, "Whisky is for drinkin'; water is for fightin'."

Summary While water rights issues are complex, 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. Even with this minimal knowledge, lenders can identify loan applications 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.

²This is not to say that a lender should only be concerned about water rights with respect to its agricultural borrowers. Any commercial enterprise that does not receive its water supply from a public water system must have a legal right to divert and use water unless they fall under the limited number of statutory exemptions for small volume uses.

³The comparison of the relative merits of these valuation methods is beyond the scope of this article.

⁴In many parts of the West, it is not uncommon for a water right with an 1870 priority date to be curtailed in mid-summer during a dry year.

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