July 2, 2015

Due Diligence in Agricultural Land Transactions


By Steve Shropshire

From the Jordan Ramis Archives

A lawyer advising agribusiness clients of any size will inevitably be asked to assist one of those clients with an agricultural real estate transaction. Generally, as a lawyer, this means you will be assisting with the preparation or review of the transactional documents. However, an equally important task is that of guiding your client through the due diligence process. This is the investigatory process during which a prospective purchaser tries to determine whether there are any legal or physical defects that would make a property less attractive to the purchaser.

In recent years, this process has become increasingly important. The number of external issues impacting agricultural landowners has continued to increase. These issues range from domestic water supply regulation to endangered species protection. As a result, simple land transactions may now implicate local, state, or federal laws. Likewise, neighborly agreements once sealed with a handshake may erode or disappear entirely when a new owner moves in next door.

An attorney familiar with these issues is better equipped to assist both sellers and buyers during the early stages of an agricultural real estate transaction. This article presents a brief overview of some of the primary issues of concern for a prospective purchaser, and offers some tips for helping a client through the due diligence phase. Each deal will dictate the level of scrutiny to be exercised. This article is simply intended to highlight many of the most common inquiries to make when dealing with agricultural land.

Understanding the Client's Needs. The first step to successfully advising your client is to understand the client's needs and plans for the property to be acquired. You should determine how the client intends to use the property, both over the short and long-term. Does the client need improvements on the land such as a residence, storage barn, or processing facility, or will unimproved land suffice? Is topography and climate important? How important is access to transportation infrastructure, utilities, and water? Once you have developed this understanding of your client's desires and needs, you will be better prepared to guide the due diligence evaluation.

Ownership. The evaluation begins with the basic inquiry into who owns the property and what the nature of that ownership is. To start the process, the purchaser should obtain a preliminary title commitment. The commitment will show the record owner as well as any interests of record held by third-parties such as mortgages, liens, judgments, easements, and generally any deed restrictions. It is important to complete the ownership inquiry by determining that the seller has full authority to act on behalf of the record owner(s). This is particularly important where a seller may be one member of a limited partnership. The Oregon Secretary of State's office maintains records on all registered business entities, including the names of the officers, directors, or partners.

Visual Inspection. A visual inspection should be the next step once it is determined that the seller has authority to sell the described property. The purpose of the visual inspection is to determine whether there are any features or conditions on the property that may affect its value or utility. Some of the important items to include in the visual inspection are the following:

  • Walk the property boundaries looking for visible encroachments such as fences, structures, roads, or paths.
  • Determine whether there is any evidence of historic trespass, adverse possession, or prescriptive easements.
  • Determine whether there is evidence of dumping or hazardous materials disposal.
  • Note the number and condition of any structures.
  • Determine whether utilities such as sewer, water, electric, gas, and telephone appear to be available to the property.
  • Note the nature and use of the surrounding properties.
  • Look for evidence of natural hazards such as flooding, erosion, drainage problems, and fire hazards.

If the visual inspection raises concerns about the location of the property boundaries or possible encroachments, the purchaser should strongly consider obtaining a survey. Sometimes the seller will agree to fund all or a portion of the survey if there is a reason for legitimate concern. Even if the visual inspection does not raise concerns, a survey may be helpful to secure funding, a full-value appraisal, or piece of mind. Surveys are not cheap, but if your client elects to have one done, the more detailed the better. Ideally, the client would obtain a survey that shows not only the property boundaries but also the location of buildings, utilities, all recorded easements, unbuilt or underground utilities, zoning set-back requirements, and encroachments.

Physical Inspection of Buildings. Determine the condition of the heating, cooling, plumbing, and electrical systems. Determine the condition of any included equipment. Evaluate the building's structural soundness and the condition of the roof. Is there room to expand if desired? Does the topography, soil and geology appear to support any such expansions?

Deed Restrictions, Covenants, Easements and Encroachments. There are a number of limitations on the use of the property that may run with the land. Generally such limitations appear of record in the title commitment. If so, the attorney should review all referenced documents creating the limitations to determine the possible impact on the purchaser's proposed use of the property. It is sometimes possible to get the title insurer to insure over certain minor defects. More troublesome are unrecorded documents, agreements, or evidence of limitations on unfettered possession. It is common for agricultural neighbors to operate for years on a handshake. This is particularly true with regard to access to adjoining properties and water sources. It is important to determine whether such agreements exist, and if so to ask the seller to reduce the agreements to writing before selling the property. This minimizes the chances that an opportunistic neighbor would hold the purchaser hostage following the close of the transaction.

Easements/Access. It is also very important that the purchaser determine whether any easements or access rights are required to make the planned use of the property. Again, while some easement agreements may be in writing and recorded with the county, many are not. Evidence of years of historical practice may persuade a purchaser that a formal easement agreement is not necessary. However, such handshake arrangements are a common source of future conflict and cost. Although the lifelong neighbor may be willing to accommodate the entrance road expansion, the executor of that person's estate may not be.

Environmental Contamination. If the historic use of a property has included the presence of a garage, shop, fueling area, or dump, it is prudent to contract with an environmental consultant to conduct a Phase I environmental assessment. The reason for concern extends beyond the health effects to individuals working and living on the property. Under state and federal law, the owner of contaminated property is jointly and severally liable for the cleanup of that property, even if the current owner contributed nothing to the contamination. Although the law recognizes an "innocent purchaser" defense, a current land owner must generally engage in time consuming and costly litigation before the defense can even be asserted. Then, to support the defense, the purchaser must provide evidence of reasonable investigations into the environmental condition of the property at the time of purchase. This includes, at a minimum, a Phase I assessment.

A Phase I typically includes a visual inspection, a public records review, and interviews with past owners, neighbors and other knowledgeable parties about the past use and environmental practices on the property. With agricultural properties, some of the common environmental problems can include leaking or abandoned underground storage tanks, contaminated soil, contaminated ground water, asbestos, PCBs, and illegal dumps. If the Phase I assessment uncovers evidence of possible contamination, a more involved Phase II assessment may be necessary in which the consultant takes air, soil, water, or asbestos core samples.

If contamination is discovered and the purchaser wishes to proceed with the transaction, there are a number of mechanisms to reallocate some of the joint and several liability risk. These risk allocation mechanisms are beyond the scope of this article, but include indemnification agreements, prospective purchaser agreements with the Oregon Department of Environmental Quality, or environmental insurance.

Water Rights. Oregon law requires all landowners to hold a water right from the state before withdrawing surface or ground water for beneficial use. If a purchaser intends to use the new property to grow crops or even raise livestock, valid water rights should be an essential component of the transaction. Conducting a due diligence evaluation of water rights is more of an art than a science. This is, perhaps, one of the reasons why title companies will not insure water rights in Oregon. Although available space does not permit a full discussion of this topic here, the next issue of the newsletter will contain a follow-up article on the evaluation of agricultural water rights.

Despite the complexity of a detailed water rights analysis, there are several basic aspects that the non-water law practitioner should keep in mind. A water right generally runs with the land in Oregon. However, like a mineral right, a water right can be severed from the underlying property and transferred to another property or instream use. Therefore, it is crucial to first confirm that the property has appurtenant water rights that are not subject to any assignments, transfers, leases, mortgages, or liens. Next, the purchaser should determine the nature of the water rights. Some of the important questions are:

  • Does the seller hold only permits (an inchoate right to begin using water subject to proof of beneficial use) or certificated or adjudicated rights?
  • Are the water rights appurtenant only to that to that property or shared with others?
  • How many rights are there?
  • Is the water supplied by an irrigation or water district?
  • How much land can be irrigated?
  • How much water can be used?
  • What is the authorized season of use?

Next the purchaser must determine whether the water right has been exercised to its full extent. If not, it may be subject to abandonment or forfeiture. Finally, the purchaser should evaluate the reliability of the water supply. This will depend to a large extent on the priority of the water right. In Oregon, senior rights, or those with the earliest appropriation date, must be satisfied in times of shortage before junior rights may divert water. Reliability will also depend on local climatic or hydrologic conditions. Finally, as has become evident in the last few years, the presence of endangered species may drastically affect the availability of water for agricultural use. Lastly, the purchaser should determine whether written easements or other agreements are in place to guarantee access to headgates, wells, and pipelines if located on a neighbor's land, state land, or federal land.

The answers to most of these questions can be obtained through a combination of field investigation and paper research. Start by obtaining a complete copy of the water right files from the Water Resources Department in Salem.1 Compare the file with field observations or aerial photo review to determine whether the actual use of the water rights appears to be consistent with the paper rights. Interview the local watermaster, because that person is likely to be familiar with the property in question and the water rights associated with it. He or she will probably be able to provide information on the historic use of the right and its seasonal reliability. If there are questions about the use of the rights, interview the seller and neighbors to get additional information.

Utilities. If your client intends to add improvements to agricultural land or modify those already on site, it is important to determine the availability of utilities. Does the property have ready access to electric, gas, telephone, cable, sewer, and drinking water? If so, try to determine the age of the infrastructure and assess its condition. A new septic system may require extensive environmental permitting and expensive technological upgrades. If the property obtains its drinking water supply from a well, ORS 448.271 requires the seller, upon accepting a purchase offer, to test domestic well water for nitrate and coliform bacteria contamination and supply the test results to the prospective purchaser.

Environmental Permits. It is possible that operations on the property require certain environmental permits. Such permits may be required for activities in wetlands or riparian areas. They will also be required for the operation of a confined animal feeding operation, including certain seasonal feeding of range cattle.

Mineral Rights. Mineral rights, like water rights can be severed from the surface estate and conveyed to third-parties. It is important, therefore, to determine whether the mineral rights have been previously conveyed or leased. If so, the attorney should determine the scope of the third-party's rights to explore and extract the mineral resources beneath the property. The title commitment will indicate whether there are any conveyances of record and the documents that evidence those conveyances.

Leases or Other Contracts Running with the Land. It is very likely that the seller of agricultural land is benefited or burdened by a wide variety of leases or other contracts that may run with the land. It is important for the purchaser's attorney to identify these agreements in the due diligence process so that purchaser evaluate the value or cost of the agreements on a prospective agricultural operation. Examples of such agreements include the following: federal grazing leases, Bureau of Land Management permits, United States Forest Service permits, crop leases, residential leases, hunting permits, timber permits, and conservation easements. Some of these agreements may be recorded. However some may not even be in writing. Again, the purchaser should attempt to get such agreements in writing where the agreement adds value to the property.

Land Use Concerns. Generally agricultural lands are zoned EFU or exclusive farm use. This is a highly restrictive zoning category designed to protect productive farm or ranch lands and keep them in production. Although Oregon has state-wide land use laws, they are generally implemented by county governments through county planning and development codes. For this reason, it is important to understand the laws of the local jurisdiction in which the property is located. These laws may protect the property from encroaching development, but will also restrict what a purchaser can do on the property. For example, certain jurisdictions may have overlay zones that expand or restrict otherwise normal EFU uses. For this reason, it is important to discuss possible future use of the property with the purchaser and then determine if local land use laws will allow such use.

Financial Issues. There are a variety of financial issues that can arise during the diligence phase of a real estate transaction. A discussion of these issues is beyond the scope of this article. However, they may include: financing contingencies, terms of assumed financing (if permitted at all), insurance availability, tax considerations, and payment of broker commissions or finders fees.

1Much of the basic water rights information is now available online at www.wrd.state.or.us.

This article is intended to inform the reader of general legal principles applicable to the subject area. It is not intended to provide legal advice regarding specific problems or circumstances. Readers should consult with competent counsel with regard to specific situations.

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