I had a similar issue, but in slightly different circumstance. I was working on a new machine (Vista SP1) that didn't yet have IIS even installed.
When I went to upgrade the web project, I got this error. Running as Admin did not fix the issue, but thanks to the suggestions in this forum, it pointed me to the fact that the upgrade was trying to access the IIS application linked in the web project. That didn't exist on my machine, and thus the error.
My solution was to create a new web project that ran inside the visual studio web server. I then compared and merged the new web project's settings with the old web project.
This effectively changed the old webproject to run in the vs web server instead of (the missing) IIS. I then re-ran the upgrade and it completed flawlessly.
I do agree that the user experience on this issue could be improved. My user experience was sufficient only because it happened to include this forum :D