Some people in New Zealand were being monitored "very closely", Mr Key said, but he cautioned that the greater risk was posed by "the ones you don't know about".
The Prime Minister believed New Zealand was well-prepared to deal with any domestic threat, which he said was much lower than other countries.
Last week, Parliament passed new terror legislation aimed at stopping would-be foreign fighters from leaving New Zealand to join Islamic State (ISIS) in Iraq or from carrying out terrorist acts in New Zealand.
But Mr Key said countries such as Australia, Canada, and the UK have tougher legislation than in New Zealand.
Domestic terror threats were an "unfortunate reality" in the modern world, he said, and the Government must ensure that its intelligence agencies and police departments are well resourced.
Their capabilities must be under constant review, he said.
"Unfortunately, as we saw yesterday, there are some very sad and sick individuals in the world and they are susceptible to the kinds of messages that people like Isis are putting out there via social media - that is just the reality of the modern world we live in - they tap into people who are very disenfranchised for a variety of different reasons. They in themselves pose a domestic risk," Mr Key said.
"The good news about New Zealand is that I think that risk is much lower than many other countries but nevertheless it's a risk we can't ignore."
Intelligence agencies have identified 30 to 40 people as posing some form of risk to New Zealanders.
They were being monitored closely, he said, "for very good reason".
"As Prime Minister I can't just have intelligence agencies that feed me reports that tell me there are, from time to time, risks, and do nothing about it. If I was to do nothing about it, then rightly so, if there was a problem people would criticise me," Mr Key said.
"But whatever the level of legislation you pass, or surveillance you undertake or monitoring that you do, there's still always a risk. That's proven to be the case in Australia, Canada, the UK and the United States."
The events in Sydney yesterday had New Zealand joining the "great sorrow and sadness" of its "best mate" across the Tasman, Mr Key said.
While he didn't think it would mean a re-evaluation of sending troops to the Middle East to fight Isis under the Anzac badge, he said the world had to stand up to the terror group.
"In the end... there's only two ways the world can go - one is, to be scared of them and to allow them to gain more territory and control; or ultimately stand up to them," he said.
"Countries like New Zealand have a responsibility actually to stand up to a terrorist group that undertakes, not only brutal actions of its own, but encourages other people to do the same thing."
Mr Key said he had no advice that suggested the Sydney siege would elevate the terror threat level in New Zealand.
The Man behind the siege
The self-styled sheikh behind a siege in the heart of Sydney was a violent offender, charged as an accessory to murder and with multiple sexual offences, who harboured deep grievances against the government, which he blamed for taking away his children.
Man Haron Monis, an Iranian refugee described by those who knew him as very unusual and a loner, was killed early on Tuesday after heavily armed police stormed the Lindt Chocolate Cafe and freed about a dozen hostages to end to a 16-hour siege.
Last year, Monis was charged as an accessory to the stabbing murder of his ex-wife, who was set alight in a Sydney apartment block. He was charged this year with the indecent and sexual assault of a Sydney woman. More charges were laid in October.
He was also found guilty in 2012 of sending threatening letters to the families of eight Australian soldiers killed in Afghanistan.
Such a long list of charges and offences has raised questions about whether authorities should have done more to stop Monis.
His website, now taken down by authorities, paints a picture of a man unraveling, enraged by the Australian courts and by perceived injustices against Muslims in Iraq and Afghanistan.
"Man Haron Monis ... has continuously been under attack & false accusation by the Australian government & media since he started his political letter campaign from 2007," Monis wrote on the website.
"His children have been taken away from him by the Australian government and he is not allowed to visit or even call them," he said.
"A VERY UNUSUAL GUY"
Sydney-based criminal defence lawyer Adam Houda, who represented Monis over the letters sent to the soldiers' families, described him as a deeply unsettled loner, wholly apart from Sydney's tight-knit Muslim community.
"He was a very, very, very unusual guy and he had no affiliations with any group. He operated alone. He was a lone wolf," he told Reuters.
"So I found him very unusual in that regard - that nobody knew him, you know," Houda said.
Monis' website offers perhaps the keenest insight into the motivations behind his decision to seize an upscale cafe in Martin Place in the heart of Sydney's financial district.
The website shows graphic images of children that he says were killed by U.S.-led coalition air strikes, as well as media coverage following Monis' court appearances and statements addressed to the Muslim community and Australian Prime Minister Tony Abbott.
He compares himself to Wikileaks founder Julian Assange, saying that he was being persecuted by the government for his political beliefs, and rails against the government for the sexual assault charges laid against him.
"Since the Australian government cannot tolerate Sheikh Haron's activity, (it) is trying to damage his image by these false accusations, and also for putting pressure on him to stop his activity and keep him silent," he wrote.
Abbott confirmed on Tuesday that Monis was well known to police. New South Wales state Premier Mike Baird declined to comment when asked by a journalist whether it was appropriate for him to have been granted bail.
Police must focus their limited resources on groups attempting to pull off spectacular terrorist attacks, Greg Barton, director of the Global Terrorism Research Centre at Monash University, told Reuters.
There are only a tiny category of people at any given time police can legally and financially justify keeping under surveillance, and Haron simply did not qualify, he said.
"Yes, you could put him under 24/7 surveillance, but you could only ever afford to put on a few people at once and, on the triage priority list, he would be well down that list," Barton said.
"I don't think it's a case of a failure or a mistake. I just think it's a case of the harsh reality of dealing with this kind of threat."
Reuters/NZME.