This minimizes interest expense and maximizes the pay down with 100% of the payments through May 2015 reducing principle. 

If your 4% number includes these and if your cost of money is about 4%, then you will be feeding the principle reduction and your total return will be the potential appreciation. 

A higher debt service may require you start with those smaller properties to pass loan criteriaIn the end it depends on your cash flow objectives and how many properties you want to manage

At the end of the day, each opportunity has to be evaluated on its own merits mapped onto your personal investment objectives.

I was thinking of proposing the followingthe first 5 years principle only, with a refi-at the end/or not...

Establish written, objective and legal tenant screening criteria.

You have to tell me, but let's say it's $1,000If I'm a buy and hold investor looking for positive monthly cash flow of at least 10% per year, I need to make a net profit of $125 per month if I were to pay off the existing $55K mortgage using a conventional 20% down mortgage, 6% APR based on the following:Mortgage owed: $55K20% down = $11K + closing costs = required investment (say $15K)10% ROI on investment = $1,500/year = $125/monthNew mortgage owed: $11K with a monthly payment of $386 principle and interestEstimate taxes and insurance at $175/month based on 3%/year of market valueMonthly PITI cost: $561/monthOther property management costs: $200/monthTotal monthly cost: $761/monthMonthly rent: $1,000Monthly profit: $239/month = 19% ROIInvestor is looking for 10%, so you give the investor $125 and you split the rest of the monthly profit between you and the seller ($114/month)Takes 175 months (over 14 years) for you and the seller to make $20K, but you've made a deal where you've sold house so there's no mortgage on the seller's credit (didn't do subject to or seller finance), there's no out of pocket costs for you or the seller, you both have monthly income for the life of the mortgage and you can actually create second and third mortgages against the property to secure your position, so if the new buyer sells, you must be paid your $15K and $5K respectively.There are a whole bunch of assumptions that you will need to verify and tighten, but the concept I am trying to show is that you can always make a deal even when there doesn't look like one. 

On the first option, are there any restrictions...as I see it, the objective is to get a tenant to pay principal and assume the difference of the payment and what is due owner...And does it make any sense to put personal capital into this property: i.e. do I have incentive to rehab this place to rental status...

@Nathan Song  - and what's the interest vs. principle ratio?

So your first objective is to flip yet it sounds like it may end up a rental.