Because this is said as an explanation of Jesus' initial statement, being "born of water and the Spirit" is the same as being "born again" or "born from above." In that sense, as used here by Jesus, both "water" and "spirit" are spiritual entities.
It is easy to jump to the conclusion that Jesus' mention of water refers to baptism. However, as a figure, the part water plays is more complex than is commonly assigned in this context. Consider this: From righteous Abel on, all have been and are being saved by the same process encompassed by the grace of God. All must be called by God, all must repent and receive forgiveness through the blood of Jesus Christ, and all must be given God's Spirit. Note, however, that there is no mention in Scripture of any of the saints who lived before John the Baptist being baptized. This includes those who were under the Old Covenant. If all are to receive salvation by the same means, why does the Bible fail to show any of them being baptized?
It is more likely that the "water" and "spirit" Jesus refers to are those mentioned in Ezekiel 36:25-27:
Then I will sprinkle clean water on you, and you shall be clean; I will cleanse you from all your filthiness and from all your idols. I will give you a new heart and put a new spirit within you; I will take the heart of stone out of your flesh and give you a heart of flesh. I will put My Spirit within you and cause you to walk in My statutes, and you will keep My judgments and do them.
In this prophecy, Ezekiel indicates a cleansing from spiritual filth and a change of heart, from which spring obedience to God's commands. As the prophecy clearly says, both the water and the Spirit are from God above and precipitate the cleansing and birth that Jesus teaches in John 3. God says He will "sprinkle clean water," but as we know, that does not indicate the waters of baptism, since true Christian baptism is an immersion. Notice what John the Baptist says in John 1:33: "I did not know Him, but He who sent me to baptize with water said to me, 'Upon whom you see the Spirit descending, and remaining on Him, this is He who baptizes with the Holy Spirit.'" This suggests that a baptism of the Holy Spirit is also needed, which Acts 19:1-6 confirms.
John W. Ritenbaugh
Born Again or Begotten? (Part Two)