How can I delicately propose that if he were interested, to potentially sell directly to me and emphasize that we could avoid the realtor fees in doing so? 

Are there private money institutions or organizations out there I can present the proposal to?

One way to "head this off at the pass" would be to propose a simple "hey dude, you screwed up and that sucks for me. 

The legislation doesn't seem to separate R1, R2, etc.

You may want to spend some time making friends in city hall that are on the planning/ zoning board they can help to give you insight on how to rezone the property (usually it takes a couple months, you'll need to file paperwork, pay fees, get an architect to draw up your proposed plans etc) attending zoning board meetings can prove helpful as well, perhaps you'll pic up some inside info there that can be used in your next deal. 

@Will Barnard I could be wrong but I thought that the state legislators, wrote all the real estate laws and the purpose of the CA DRE is to enforce the laws not to make them, and in the case of conflicting laws the stronger/ more restrictive one is the one that takes effect.

I agree with @Andrew B. what you are proposing is a hidden late fee factored into the rent. 

Let me know if I could leave it as-is or should try to change it.Current layout (exterior wall with window is on top):Here is my new proposed layout.

I was actually calculating the PTI into my numbers already on the fly my apologies for the confusion.But with that being said my monthly payment would be $965 including the Property Manager and PTI using those terms.Another option that I would like to propose would be if I just give her more equity in the deal.

They will recommend approval/denial/any changes to the proposals.