I'm a landlady too and I think first and foremost you need to make sure it really makes sound financial sense to convert the loft. Even with the better rate you say you will be able to benefit from, by how much do you stand to benefit once you have paid for the works on the house? Would it make a significant difference to the rent you could charge and is there a market for the property where it is located if it's bigger and at a higher rent? If you are thinking of selling in a couple of years you need to have researched what % increase in value a loft conversion will add and look at whether you will recoup your costs.
As for the tenant, if you really want to go ahead with the work, tell the tenant your plans and give her the options as you see them. Your relationship with her is a business one and as long as you are reasonable and stick the terms of the tenancy and the law, then that's all you really need to be concerned about. If you were to make the house bigger, keep the current tenant and not raise the rent then you need to be sure that the loft conversion still makes financial sense in the longer term. The flip side is whether you can afford the mortgage without a tenant while the works are done.
I'm not sure I understand your Option 2 - if you are not charging rent while the work is being done, surely that is the compensation for putting up with the building works? If the tenant doesn't want to be there because of the works, she has the option of giving notice and providing there is a market for your property in the local area, you can get another tenant once the works are finished and, as RandomMess says, at a higher rent. If you provide extra compensation in addition to not charging rent it makes you seem rather desperate to keep someone who doesn't (from the info provided) sound like the 'perfect' tenant.