Assuming this is legal in my city having 3 people in a 1 bedroom unit, are there any down sides I should be aware of? 

But not only do you have more upside you have less "potential" downside.

1) Use it to purchase primary home, keep for 5+ years and then do a cashout refior2) Go straight to buying rentals that may or may not cashflow nowChoice 2 has the issue of further downside risk in addition to negative cashflow (tenant issues etc) in a correcting market.I would like your takes to this scenario, you can propose a third/creative option if you'd like.

This type of deal is tough because your agreement can be deemed invalid if she was not of the (right sound mind) when the transaction happened.It could be very bad press for your investment business also if it goes south.Some deals are just not worth taking on because of the layers of potential downsides outweigh the upsides. 

A little bit of a lag between when the renters starts the process and when it hits the bank , that is the only down side that we have seen. 

(Understand this is a CPA question, but appreciate any help)4) Are there any downsides of having an LLC vs. one of us investing in their name? 

The downsides are that it is in a lower lying area and could be in a flood zone so insurance might be much higher.

It would remove the doubt from your position and I fail to see a downside.

Or just someone taking huge calculated risks with little downside?

There's plenty of other downsides to it such as jealousy, risking relationships, etc.