I put 3/8" drywall directly over the wood paneling to save on time and demo cost, however in hindsight I maybe should've pulled it off because it probably didn't save me much.

Here is a list of issues that need to be fixed in my next project.....Demo Kitchen - Order Cabinets, Order Countertops, Purchase Appliances, Gut Master Bathroom - Build A Shower, Tile Shower, New ToiletRip Out Existing CarpetRefinish Hardwoods Under CarpetVinyl Flooring (Tile Over It?)

I like to start off a gut and remodel by hiring a demo crew. 

If I demo the old home, split the lots into two 30,000 sq. ft. lots, and build new homes on both lots that will sell for 600,000 a piece is it worth the 400,000 asking price?

For example, they want the garage demoed and replaced, they want the roof replaced, and many more.

Maybe demo some. 

Does it function as the demo shows?

As Matt said, it is doubtful that the room / area was permitted and if you plan on enclosing it to make it usable square footage especially in CA, you will more than likely need to demo it and build the space out per code and per zoning restrictions. 

Best to keep your tenant happy, but make sure YOU and your tenants are not the ones who ends up having to clean up after them, unless it's super important to save money for you, and you're willing to take it on.Tradespeople are often not set up to demo things, and they don't feel like they should have to;  they charge their normal rate like $160 an hour when it would save so much money and be quicker for you to have a laborer or yourself there to make the contractor's job easier.   

Just had some sinks and a bathtub in the living room for a while :) - but luckily they hadn't started demoing yet.