There is nothing wrong with denying a Sec. 8 tenant if they can't afford the rent you are seeking.  

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. 

Is there any regulation for an actual health concern?

However, nonqualified use does not include any period of such use that occurs (1) any time during the five-year period ending on the date of the sale that occurs after the last day of use as a principal residence, or (2) any time (up to two years) that the taxpayer is temporarily absent due to a change in place of employment, health, or unforeseen circumstances. 

Owner is an aged widower man in failing health that NEEDS to move to a nursing home or assisted living facility. 

@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.

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