Water rights are key to the American West. What are they, how do they work, and where might there be investment opportunities?

“I really think this emotional charge that we all have around water is in part because you can only live three or four days without it. So, when it gets scarce, that sort of primal, ‘I’m taking care of my family’ instinct kicks in.”

Those are the words of Gary Barber, Vice President and Partner of Hydro Source, Inc., a water rights consulting and brokerage firm based in Colorado that provides services throughout the western United States. A former commercial real estate broker and project manager, Barber began working on water rights assignments more than 25 years ago and it’s been his focus ever since.

Full disclosure: Barber is my broker. He’s currently working on an assignment to potentially dispose of water rights that my family holds in Imperial County California that are tied to a former gold mine we own. (If anyone is interested in the water or the mine, feel free to reach out!)

That said, this conversation with Barber was conducted entirely from a journalistic perspective. While I am an owner of water rights, my understanding of how they work has always been hazy at best. In speaking with Barber and other experts in the space, I wanted to enhance my comprehension of this rather esoteric concept; one that is tangential to CRE but also essential to the industry’s continued expansion, at least in the West.

I also wanted to better understand the opportunities that might exist for investors to profit off water rights. I was curious if there is a speculative market for water, and if investors “bank” water in a manner akin to land.

Accordingly, this article will attempt to demystify water rights for the Thesis Driven faithful, tackling:

• What is a water right?
• Who needs water rights and how are they measured?
• How are water rights transferred?
• Can you speculate on water rights?
• What is the future of water rights?

Because water rights vary by state, it’s worth noting up front that we’ll be focusing on the approach in Colorado for the purposes of this article. California, for instance, has a somewhat different bureaucratic approach to water, though a lot of the core principles and concepts remain the same.

Water Rights 101

Let’s start with the basics: a water right is what’s known as a usufructuary right.

Don’t worry if that term is new to you. I had never heard it either until recently. It was introduced to me by Adam DeVoe, owner of DeVoe Law, which is based in Denver, Colorado. DeVoe’s practice comprises about 50% water rights cases and 50% other environmental issues. DeVoe started his own practice at a less than fortuitous moment: March 2020, right before the Covid-19 pandemic kicked into high gear.

Despite that dubious beginning, DeVoe said his practice has flourished over the past few years. That’s not terribly surprising because water rights are critical in Colorado, and DeVoe has spent his career developing an expertise in them. He was previously the primary litigator in Colorado Water Courts for the city of Aurora and has spent a good portion of his 25-year career focused on water rights.

Like “usufructuary,” the idea of a “Water Court” may be making your head spin a bit; give me a moment—we’ll get there. But first, back to usufructuary.

Essentially, a usufructuary right is a fancy legal way of saying a right of use. In other words, it’s not property. You don’t own the water; you own the right to use the water. You can extract or divert the water from its natural setting, say the Colorado River, and apply it to some “beneficial” use, such as farming, mining, real estate development, municipal water supply, etc.

“That’s all a [water right] is,” DeVoe said.

Water rights are measured, pretty much everywhere in the United States, in terms of “acre-feet.” One acre-foot is the amount of water that would cover one acre of land to a depth of one foot. It is equal to approximately 325,851 gallons.

Water rights in Colorado are granted by the aforementioned Water Court. There are actually seven water courts in Colorado—one for each of the major drainage basins in the state. If you want to obtain water rights, you need to go before the Court and apply for those rights. In the process of doing so, you need to prove, with the help of engineers and attorneys like DeVoe, that your use of the water will not “injure” the use of water by someone else with a prior water right.

This is critical because water rights in Colorado work based on a priority system, and that priority is entirely determined by when the water right was granted. So, if your water right dates to when the State of Colorado was founded in 1876, you get to take all the water that was granted to you by the Water Court before anyone with a water right dating to 1877 gets to obtain their water. If the available water runs out before you reach rights holders from 1900, or 1956, or 2024, that’s just too bad for them. Barber compared it to the methodology Southwest Airlines uses to board its flights.

Buying, Selling, and Transferring Water Rights

As you might expect, water rights in Colorado, and throughout the Western United States more or less, are currently “over-apportioned,” as DeVoe put it. That means there are more water rights then there is water to go around. Thus, in a state like Colorado that works on a priority system, you could theoretically go to the Water Courts and have a new right granted. But that 2024 water right wouldn’t do you much good, because there’s almost no chance that there would still be water available by the time your turn at the metaphorical well arrived.

This is why a rather thriving market for the transfer and sale of water rights exists throughout the Western United States.

Let’s play out a hypothetical scenario here. You’re a single-family home developer erecting a new subdivision 20 miles from downtown Denver. To make this project feasible, you need to be able to provide water to the 100 new homes you plan to build.

As we covered a few paragraphs ago, you can’t just go to the Water Courts and ask them to grant you water rights, because even if you’re successful in that endeavor, you’re going to be so far in the back of the queue that your prospective homeowners won’t be able to get a drop from their future faucets.

So, instead, you find a farmer; or more likely you hire a water broker like Barber, and he finds a farmer for you. This farmer has water rights dating back to the 1800s and he’s got enough acre-feet to supply your entire development.

This farmer, will call him Bill, is ready to hang up his backhoe. He’s in his 60s, and his kids aren’t interested in pursuing a life in agriculture. His farm is in a remote part of the state, which means that the land doesn’t have significant value. But his water rights, which can be transferred to any part of Colorado, are a different matter.

According to DeVoe, for many farmers in Colorado today, this scenario represents their “long-term retirement plan.”

Of course, that doesn’t mean the process will be easy. To transfer those water rights, our developer and farmer duo will need to pay a visit to the Water Court, where they will be in the unenviable position of attempting to, as Barber put it, “prove a negative.” Specifically, that this new use of the water won’t cause “injury” to any other existing holders of water rights.

To demonstrate that, the services of engineers, lawyers, and other consultants will be solicited. A contract will be arranged between the farmer and developer stating that the developer will pay $X per acre-foot for the water rights, with the exact number of acre-feet to be determined by the Water Court. This is, essentially, the same concept as when a developer buys property from a landowner with a zoning change contingency.

“This is where it gets really complicated really, really fast,” DeVoe told me. “You either buy a more senior water and change it in the Water Court to your place and type of use, or you buy another water right and you go through a process of getting a decree for what’s called an augmentation plan or an exchange plan. What this allows you to do is take water at your location and release this purchased water at some other location so that other water rights users are not injured by your new diversion. And you replace those depletions through augmentation or exchange from this other water that you’ve purchased.”

Water Rights Speculation

Still with me? Good, now let’s talk speculation.

Firstly, I need to warn you that the word “speculation” is to water rights, particularly in Colorado, as the word Voldemort is to Harry Potter.

“I probably can’t say it emphatically enough: there’s a very strong bias against speculation,” Barber said.

When I asked DeVoe about speculators he was similarly inclined. “I wouldn’t call them speculators,” he told me, when describing individuals who might, perhaps even incidentally, achieve a profit from buying and then selling water rights. “Because it’s such a dirty word in Colorado water law.”

As DeVoe explained it to me, this bias against speculation is reinforced by the nature of the water rights themselves. Specifically, that to retain a water right, you need to actively employ it.

“So, a holder of a water right that has a relatively senior priority and could be diverting their water has two separate but related considerations. One is if you do not use the water right at all in a 10-year period, you can be put on what is called the “Decennial Abandonment List” by the state engineer’s office,” DeVoe said. “What happens when you’re put on the list is that there is a presumption that you have abandoned that water right through non-use. You have an opportunity to come into Water Court and demonstrate that you had no intent to abandon the water and can explain extenuating circumstances to the Water Court and protect the water right. So, that’s one consideration is the complete loss of the right.”

But there’s another issue that water rights holders in Colorado need to be mindful of. Let’s return to our hypothetical scenario with the farmer and the developer. When they go to the Water Court to have the rights transferred between the parties, the Court is going to scrutinize what’s referred to as “historical beneficial use of the right.”

To translate that from legalese: to what extent has the existing right holder, our friendly farmer, actually been using the rights he holds? Ultimately, the Court’s assessment of the farmer’s average annual usage is what will determine how many acre-feet can be transferred from the farmer to the developer.

In other words, not only do you have to use your water rights to retain their value, but you want to exercise them to the greatest possible extent to maximize that value. This potential discrepancy between what a water rights seller has and what the Court will allow them to reassign to another user is why almost all water rights transactions occur on a contingency basis.

“So, if you’re a farmer on the front range with an 1870s water right, you want to be using every drop that you can use at all times,” DeVoe said.

The need to use the water right makes a pure speculation play challenging. Unlike land banking, you can’t just hold the right, pay some taxes, and wait for its value to increase. You have to find a use for it in the interim, which creates both financial and logistical challenges.

Nonetheless, DeVoe conceded that some accidental speculation can occur. He outlined a scenario in which that can happen, usually with a developer master-planning a large scale, mixed-use development.

“You [the developer] get a good deal on a water or a set of water rights to support a plan you actually have in place. It happens to be more water than you really think you’re going to need, but you might be in a municipality where there’s a water banking system and there are lots and lots of these,” DeVoe said. “So, what you do is you buy up all this water, you transfer it to the city, the city puts it in what’s called a water bank, and they issue some form of [water rights] credit. It’s really more credits than you can actually use in your development, but you’re thinking ahead that somebody else is going to put a development in on land you don’t own and control, and they’re going to need those credits and they don’t have any water rights, so they come to you to buy your credits. That happens.”

DeVoe said that some large-scale developers that build out the water infrastructure for a master-planned development will choose to retain those water rights and become the water utility for these “metro districts,” which he described as “a special kind of quasi-governmental entity in Colorado that owns, manages, disperses, etc. [water].”

But DeVoe said that those revenue streams were ancillary not primary. “There is some money that comes from the owning, managing, and running of those water districts. But all of the real money is in the real estate development.”

The Future of Water Rights

According to DeVoe, municipalities can also take on a pseudo-speculator role at times.

In Colorado, municipalities have the right to project their water needs up to 50 years into the future and to acquire rights accordingly. I asked DeVoe if this occasionally led to a municipality buying more rights than it needed, and then profiting off the sale of the extraneous rights to another municipality or entity.

“That has never happened in 25 years of practice for me,” he said with a chuckle. “The biggest problem in Colorado is lack of forward thinking.”

Of course, myopia isn’t the only constraint keeping municipalities from planning ahead.

“Water rights and water infrastructure is extremely expensive. And what happens more often than not is that cities simply do not have the financial resources to buy all the water they could possibly need for the next 50 years,” he added.

He said that this can create significant problems for municipalities.

“You see it more in Arizona than you see it in Colorado, but [a municipality] literally just starts to run out of water. And then they go into emergency planning mode where they’re buying water at above market rates to shore up their water supply.”

This is one of the reasons that water rights have risen in value dramatically over the past two decades. It’s why the water rights associated with my family’s land are now potentially more valuable than the relatively substantial gold reserves that still remain there.

“Since 2017, when I started working with Hydro Source, we’ve seen the price of a single-family home, municipal acre, foot of water in the growth areas around the Denver metro area go from $30,000 to $60,000 an acre-foot,” Barber told me.

That increase in price and the scarcity it suggests concerns Barber. “It’s my personal opinion that we’re bumping up against many of the limits of the whole system,” he said.

And that’s particularly challenging for municipalities, because once water rights are granted, you can’t really take them back. “Once you hook up somebody’s house and sell them water by the gallon, you don’t have the ability to say, ‘we’re going to drop about 10% of our customers because we’re just running out of water,’” Barber said.

On a more positive note, Barber said that municipalities have become increasingly efficient at how they deliver and reuse water via “zero escape” policies. He also noted that, historically, “human ingenuity keeps coming forward with solutions.”

DeVoe shared Barber’s concerns and expressed similarly cautious optimism about Colorado’s ability to find viable solutions. In particular, he believes that a great emphasis on water storage via dams, an approach that’s been out of favor for a long time, could be a solution for the state.

“The hydrographic peak changes with climate change,” DeVoe said. “That means that we get more water earlier in the year in certain parts of the state and more water later in the year in other parts of the state. And the way that you solve that, instead of trying to change the way you do agricultural or municipal supply and demand, is you store it. You grab it when it’s there, and you use it at a later time.”

But despite the state’s best efforts, DeVoe made it clear that water rights will continue to get more expensive for the foreseeable future.

“It is just a simple fact of current human existence that the west and southwest is growing at a rate that is outstripping the available water supply, while apparently climate change is limiting the water supply,” DeVoe said. “Whether you are a current water rights holder, a future developer, or somewhere in the middle, [water rights] are going to get more expensive, they’re going to get harder to find, and it’s going to become more difficult.”

This article was originally published in Thesis Driven and is republished here with permission.