Basement unit in need of rehab: How much to upgrade?

[Lynn Baru]

Question for the group:

We have a 3BR, 1Ba single family home in an excellent location (28801, between Merrimon and Charlotte streets near downtown for the Ashevillians) with a 2BR/1BA basement apartment that has a separate entrance. Home is from the 1920s and upstairs has a lot of original character. We had a horrendous mold outbreak in the downstairs unit and had to gut it.  We are now faced with the following options fro renovation:

1) Basic rebuild with minor upgrades to layout (better lighting, better bath, a bit more open), materials for 89K. Would still be a 2BR/1BA. Rent estimate: $1600/mo

2) Expand the unit by 280 sq feet and make it a 3BR/1BA apartment with an open kitchen/living/dining space for 140K.  Median price per square foot in this area is $360 (although this is a lower level unit so assume premium for these square feet would be lower?). Rent would be ~$2000-2200. 

Note: upstairs currently rents for $2600. Current estimated value of this home is ~$750K.

We may have an option to take a loan for the 140000 at 5.75% via a cash out refi on another unit.

What would you do? Would you worry about undermining the value of the single family home by creating a 3BR apartment in the lower level? Where would you target your amenities?

Parking is an issue but we could turn the backyard (which isn't used) into a parking area.