The Bavarians won the competition last season as part of a historic treble and face a last-16 clash with Arsenal, which the club beat en route to to the title in 2012-13.
Los Blancos are still desperately searching for their 10th European Cup, but the Italian coach feels that Pep Guardiola's men are the best bet for the title.
"Bayern Munich [play the best football in Europe]. They play as a whole," he told the Corriere dello Sport. "They're the true favorites for three reasons. Firstly, they're a strong team with a coach who knows how to win the competition. Secondly, they're champions and this is important. Thirdly, they have already won the league in practice and can devote their resources to the Champions League. I think the latter is the most important reason.
"La Decima is the dream for every Madridista. At the [Santiago] Bernabeu we'll play big games."
Meanwhile, Ancelotti has spoken of Cristiano Ronaldo's importance to the team, saying he gives everything for the collective cause.
"He's a talent who is highly professional. He is very focused on Madrid, like all us. He does not live for comparisons with other players."