Hydrological models in arid and semi-arid ecosystems can be subject to high uncertainties. Spatial variability in soil moisture and evapotranspiration, key components of the water cycle, can contribute to model uncertainty. In particular, an understudied source of spatial variation is the effect of plant-plant interactions on water fluxes. At patch scales (plant and associated soil), plant neighbors can either negatively or positively affect soil water availability via competition or hydraulic redistribution, respectively. The aboveground microclimate can also be altered via canopy shading effects by neighbors. Across longer timescales (years), plants may adjust their physiological (water-use) traits in response to the neighbor-altered microclimate, which subsequently affects transpiration rates. The influence of physiological adjustments and neighbor-altered microclimate on water fluxes was assessed around Larrea tridentata in the Sonoran Desert. Field measurements of Larrea’s stomatal behavior and vertical root distributions were used to examine the effects of neighbors on Larrea’s physiological controls on transpiration. A modeling based approach was implemented to explore the sensitivity of evapotranspiration and soil moisture to neighbor effects. Neighbors significantly altered both above- and belowground physiological controls on evapotranspiration. Compared to Larrea growing alone, neighbors increased Larrea’s annual transpiration by up to 75% and 30% at the patch and stand scales, respectively. Estimates of annual transpiration were highly sensitive to the presence/absence of competition for water, and on seasonal timescales, physiological adjustments significantly influenced transpiration estimates. Plant-plant interactions can be a significant source of spatial variation in ecohydrological models, and both physiological adjustments to neighbors and neighbor effects on microclimate affect small scale (patch to ecosystem) water fluxes.