NoCalMom; I saw your post and just suddenly had this image, so I felt I should share. Now that I've thought of it, I'm thinking about doing it in my new apartment in our office room, to be playroom come christmas.
The chinese paper lanterns give off more natural and diffuse lighting, as well, to diffuse and soften the garage flourescents, you could drape sheer cotton fabric from the middle of the room, and form a sort of tent. We used to do this in our garage/playroom, with a huge sheet hung from a left over hook. If you get a large enough piece of fabric, you could actually make the entire garage a tent, which would deal with you shelving busy-ness, as well as making the garage more inviting and calming. Just put hooks in the corners of the room, and stretch the fabric to hang down from them. It's like a permanent fort. Hang the paper lantern in the middle, and voila! Also, you mentioned they avoided the garage, I would think that making it more cozy and novel would let them feel that it was 'their' space. Maybe put some pillows and/or leftover couch cushions in there, too, to facilitate their 'nesting.'
Good luck, and how cool that she set up a whole puppet show!