It does sound like a money pit and I'm skeptical about even the appearance of city water in 2-3 years. That may indeed happen . . . or it may not. City plans tend to evolve over time, and we don't know if the 2-3 years is really even in the plans now or if it is some sort of overly optimistic hope being peddled to them.
On the bright side, a 2 bedroom in-law suite sounds perfectly livable to me. Sure, it will be cramped with 3 kids and 2 adults, but many people in the world live in more cramped conditions. They need a place to go, and the fact that they have been living rent free with a relative is just one more indication that they don't completely have their act together (most adults with children in this country prefer to have their own place, of course.) So, this will give them a place to go. They will be fine living there as long as they can keep the basic bills paid. I know that I could personally swing what they are suggesting, but I don't have their existing debt . . . and I have more income and older children. But the idea, generally, is not terrible.
Does a family with 3 small children need a giant rehab project? Most do not.
Will they get it done in a year? Most likely not.
Since there is no bankroll to do it now, my estimate is that it will take them at least 2-3 years to get the main house through the renovations and whatever inspections are needed. 5 years would not surprise me at all. But, as long as they can stay out of foreclosure, that's probably okay.
My advice is just to smile and nod at this point, then say "oh, that's terrible!" whenever they complain about some expense, exhaustion from the work, or delay. If you want to keep us entertained, then periodically update this post.