Some have the risk tolerance and invest in NYC and are getting the appreciation.Are you familiar with any areas that cash-flow well?

I thought that the trade off might be worth the risk.

Best candidates for adding bedrooms downstairs for us have been basements where there is NO/MINIMAL risk of water intrusion as-is, and where there's already some finish (or mostly finished space), but just not the official bedroom.

At least not in a professional capacity, without consequence and substantial risk of liability.

Is there any way I can limit the risk?

The excitement and beauty of RE investing is that everything can be a risk, depending on who you ask. 

You need deep pockets,  patients and a high threshold to risk.

On the flip side, the terms offered are hard to beat and you can lock a rate for 30 years and eliminate the risk of future rate increases. 

If I set up such an arrangement, I would still be at risk unless he was insured correct?

Everyone says "Johns Hopkins area", but the Johns Hopkins area can mean both really nice or total warzone depending on the block.The 1% rule is relative, in Baltimore I would expect closer to 1.5% or 2% depending on the area and corresponding level of risk.