And this is a long term hold in an A/B+ area with low vacancy and good chance of appreciation.Please proceed to tear the deal apart.

Best bet may be to sell and take the proceeds and go find a better rental property.

If not I plan on taking the proceeds from the 1st rehab and rolling it into the second.I and the owners are very aware of the possibility that the loan could be called due and there is a signed DOS Disclosure addendum in the OTP contract to that effect.Any advice on funding options I might have?

Don't bite off more than you can chew, and get the advice of an experienced contractor (and some quotes too) before proceeding.

Plus when we sell a note, or get refinanced out, I will take those proceeds and get more properties back in to keep generating cash flow.

I would point out that the "lowest acceptable amount" they counter with is a net proceeds to HUD - so its the offer amount less commissions.As far as the timing goes - because of the bid opening procedure - there is no "first offer in".

My question is, do we keep the current house and use it as a rental or should we sell it and use the proceeds to fund a future deal that would bring in more cash flow?

Try to find someone that rents rooms for low income tenants, and get their advice on how to proceed, and what type of numbers they would look for when approaching a purchase for a new property.On the positive side, it's good that you're trying to think creatively about putting a deal together. 

How should I proceed?

HUD can't do anything, I can't do anything (because I don't yet own it), and the lender can't finance this type of property.Any thoughts for how I can proceed in speaking with the appraiser?