I recently upgraded a vsphere deployment from 5.1 to 5.5. I then wanted to upgrade the templates to the new VM HW and VM Tools. Upon attempting this the convert to virtual machine option was grayed out.
To fix this we simply need to remove the template from the inventory and re-add it.
To add it back to the inventory browse the datastore the template is located in. Find the .vmtx file within the VM folder name then select Register VM.