I can afford to do the remodel myself, ($125k), but a full tear down and change of use would be a much larger investment. 

That might be why they cant afford to give you as much lender's credit.

House hacking is the moset affordable way to start.

Assuming they have access to trusted and more affordable contractors and I don't have to manage the rehab (as much) it seems like a fair trade off. 

Holes in drywall, ripped furniture, stolen items.

@Erick Sembrano try the company floodsimple for coverage, they were very affordable compared to other insurers when we needed coverage on a 5 unit in a very similar situation.

Pooja, there are a lot of benefits of getting a cost seg done on a STR, since you own all of the furniture and appliances, etc.

I would advise buying a duplex in an area you can afford like Vallejo.

Also, but based on conversations with my CPA, it seems that classifying the property as investment rather than vacation will afford you an increased depreciation opportunity. 

I'm wondering, however, if that's my best first move, or if it makes more sense to keep renting and spend my $40K savings on a deposit for a triplex or quad in a place like Cincinnati where it's much more affordable and up-and-coming?