If you're really intent on keeping the resident in place then I would just have a conversation with the manager and see what can be worked out, but if they're sticking to their agreement they signed with you, than you might have some decisions to make. 

Future tenants would likely appreciate the extra storage, and it could make your duplex more attractive in the long run without the hefty upfront investment that a full conversion would require.Another idea is to repurpose the shed into a functional office space or a private workout area.

Some great resources and conversations here. 

You might even call some of your competitors and strike up conversations about how you generically want to open a bed and breakfast elsewhere and see if you can get them to disclose their occupancy percentage or any other valuable data.

Any homeowner offered these types of programs associated with allowing homeowners to upgrade their homes with solar or any type of energy conversation improvements with no money down should proceed with caution.  

In San Francisco, this choice is taken out of your hands and is instead a determination made from and by the Planning department.From an Investment POV, you are absolutely correct that combining the lower and the ground floor units is the best option to preserve your ability to perform a fast track condo conversion and generate the most equity in the shortest amount of time.

You can expand your network in this manner, which will lead to conversations with people of varying backgrounds, who may need your help.

Kyle - I'm local to the Philadelphia area and would enjoy a conversation on real estate.

This conversation would need drywall + 1 door min (not sure if a closet is also need to qualify as bedroom). 

OwnerRez has helpful recorded webinars with both platforms, where they give suggestions to improve ranking and conversions.