This isn't directly related to 121, but bears on it.From the Gates conclusion: "If a taxpayer sold some part of the underlying land but not the dwelling that the taxpayer used as a principal residence, the taxpayer could not defer the recognition of gain on the sale because the taxpayer did not sell his or her principal residence. . .If petitioners had sold their old home instead of demolishing it, they would have qualified for the section 121 exclusion.

This isn't directly related to 121, but bears on it.From the Gates conclusion: "If a taxpayer sold some part of the underlying land but not the dwelling that the taxpayer used as a principal residence, the taxpayer could not defer the recognition of gain on the sale because the taxpayer did not sell his or her principal residence. . .If petitioners had sold their old home instead of demolishing it, they would have qualified for the section 121 exclusion.

However, the ground-floor tenant has been doing some reading and has come to the conclusion that he doesn't feel safe having his family right above this equipment, so he turned off all the water heaters. 

However, when I finished the underwriting I learned that to get 7% CoC ROI  we had to offer $900k.In conclusion, ROI is a clearer indicator of whether you should purchase the property rather than cap rate.

Thanks...I appreciate your response...though I'm still somewhat baffled as to how the agent came to his conclusion since it seems so far off the mark.

From the info provided you are jumping to conclusions. 

Conclusion: The plexes on the MLS are overpriced for what you get in rent. 

Doing the math on a few properties I came to the conclusion that my pure cash flow would be close to break even until my PMI is paid off if I were to rent out both areas of the home however the pure cash flow isn’t that significant (unless I am being too conservative with what I can get for rental income which I think I am as I am a CPA and I like to look at conservative numbers).

I dropped my plan for this property - we came to conclusion that we were not ready for this big an investment, as we are just starting out. 

Notice that my decision changed as a new problem arose and a desire to sell arose as well.So train your senses to sniff out problems.Additionally, most passive investors will invests with real estate professionals because they have money and a desire to invests in real estate but:1. lack the time to look for deals themselves2. lack the knowledge to find good dealsSo when people invest with you and your deals you are giving them to invest in opportunities that they would not have had by themselves.You should be coming from a "giving" mindset instead of a taking mindset.In conclusion, by coming from a problem solver mindset is how you find deals and money.