If forced to cure - and it will be a condition of remedy - the tenant can take action against you for damages from leasing an illegal property. 

The STR regulations are very black and white and I don’t see many, if any, clients having issues with obtaining insurance if the house is in good condition.

That will require a rough and final inspection. 2) When installing drywall you will need a nail/screw pattern inspection. 3) You will need to provide 'conditioned air' to these rooms..how are you going to do this and that will require inspection.Will you have to increase the size of the electrical panel?

The property has been in excellent condition since it was built two years ago, and I’ve lived there myself without experiencing any similar issues.The lease is a standard Texas lease, and I’m seeking advice on how to approach this situation fairly.

Air conditioned air leaking to crawlspace making crawlspace heat or cold depending on season causing more power bill to tenants.

Selling a home, no matter the condition, is always about price.

Or, not deploy the capital as well with the increased uncertainty in the market/economy conditions?  

That's why they call it Sub-2, it's subject to the terms and conditions of the existing mortgage.

These loans allow buyers to purchase a property “AS IS, WHERE IS”.Renovation loans are available in 30, 20- and 15-year fixed rate terms and can be used to purchase owner occupied, second home and investment properties.By time the renovations are completed, the home needs to be in move-in, live-in condition and conceptually ready to be resold without repair issues.Other Important Items to Know about “Conventional” Renovation LoansMaximum – Minimum Purchase/Upgrade Amounts:Maximum: Limited to 75% of the “after improved” valueOccupancy: Primary, Second Homes, Investment PropertiesUnits: 1-4 unit propertiesRenovation Term:The renovation term for this program is a maximum of 180 days.The Borrower(s) is responsible for the work being completed within the escrow period.

Conventional at 5% down would cap you at 3% concessions, but generally is more lenient with employment history and property condition.