City host the Spanish champions in the second leg of their long-delayed last-16 tie at the Etihad Stadium on Friday.
Pep Guardiola's side hold a 2-1 lead after a memorable victory at the Bernabeu in February, which for Real ended with the additional woe of captain Sergio Ramos being sent off.
Ramos is now suspended for the second leg and Capello feels that could be a significant factor.
The Italian told Laureus.com: "I thought in the last two games they played before the end of the season that Manchester City were on the top of their form. They are really dangerous when they go forward.
"In the past I thought Guardiola has made some tactical faults in midfield but now, when they lose the ball, they try to recover it. The problem when you play City is how well can you defend against them?
"So, for me, I prefer Man City because, without Sergio Ramos, when you have to defend against City going forward, it will be difficult for Real."
Capello, who is an ambassador for Laureus, does not discount the chances of the 13-time champions, however.
The 74-year-old, who had two spells in charge at the Bernabeu, said: "Can Real win? It's possible because, for Real Madrid, it's normal to play this kind of game. The pressure will help Real Madrid. They finished the La Liga season brilliantly and they won the title."
Capello, who led England to the 2010 World Cup, sees the game as an interesting clash of cultures.
He said: "The history is Real Madrid. Real Madrid's background is really strong and they are used to playing these games on their way to the final.
"Man City is the new team, new history. I think they have a really important future if Guardiola stays with this team, like (Sir Alex) Ferguson with Manchester United. It will be a spectacular game for me."
Capello supports the work of Laureus Sport for Good, a global charity that supports children and young people by using the power of sport to end violence, discrimination and disadvantage.
Over the last 20 years, the charity has raised more than 150million euros for the sport for development sector, reaching and helping change the lives of almost 6million children and young people. It currently supports more than 200 programmes in over 40 countries.