If the borrower defaults, that note will be easily wiped out because the first will accrue interest, late fees, and foreclosure cost.

It is fairly common for the HOA to play a lien on title of your home (which accrues interest until you pay it off! 

One of the benefits of a Heloc, especially in the context of investing, is that you do not accrue interest until you actually advance funds.

Separately you calculate your preferred return in the same way by having a starting accrued preferred return (should be $0 to start in the first quarter), accrued pref for the quarter (multiply the ending capital account balance by the preferred return rate, divided by 4 because this is quarterly), preferred return distributions, and an ending accrued preferred return (a sum of the above three).  

In most cases, the foreclosing bank will open the bidding on the property for the amount of its judgment, which includes not only the balance of the mortgage owed, but all the costs that the bank incurred in the foreclosure suit, like attorney fees, accrued interest, and anything else they paid.

Here is what I would do, I would raise her rents in lock step to everyone's BUT I would talk with her and reassure that I will allow her to pay what she has been, and let that balance accrue.

Collateral is the property you're trying to buy, credit has to do with whether you've paid your bills on time and whether you're over leveraged and capacity or the ability to handle the debt you're trying to accrue. 

Any generated income or accrued expenses as a result of owning that property should go through my business checking account or business credit card.

Or does the interest accrue, add to the principal and simply make one balloon at the end of the term?

The money you take out is amortized over 30 years and the interest only starts to accrue after you take the money out vs a cash out refi that starts charging you once you complete the refi.