First off, this is a good problem to have! I was in a similar situation when I first started out and here are my thoughts - and what I did.
- The 1% rule is a rule of thumb only and really comes in to play when your purchasing. If you can pull the equity out via refinance to redeploy on another property, this property's cash-flow would decrease, but you'll now have two properties taking advantage of the 5 wealth creators (cash-flow, debt pay down, appreciation, tax benefits, & inflation hedge)
- It really depends on your long-term goals. If your in acquisition mode, then you'll likely not want to leave equity sitting on the side lines. If your wanting to have paid off properties, then you'll probably want to sit on it.
- I would be more concerned with your CoC return on adding the additional room. I didn't see you mention what it could rent for now without adding the bedroom, but you'll want to figure this out. (new rent - rent as is / rehab cost) * 100 will give you your return. If its less than 8-10% I would be hesitant.
When I was in this position; I did a cash-out refi to pull enough out of the house to where it would still cashflow for $200 a month (which is just my criteria) and used the cash as a downpayment on another property that cashflows a little more than $200. Prior to refi this house cash flowed about $350, both houses combined now bring in a little over $400.
Hope that helps,
Good luck with what ever you decide!
