According to Spanish media, the blast took place in a building near a nursing home and a school - and videos and images shared on social media showed rubble scattered in the street, Sky News reported.
The city's mayor confirmed there had been two deaths and said early information indicated the blast was likely caused by a gas leak.
"We didn't know where the sound came from. We all thought it was from the school. We went up the stairs to the top of our building and we could see the structure of the building and lots of grey smoke," a witness told the AP news agency.
The nearby school was empty, according to TVE, because classes had not resumed yet following a record snowfall in the Spanish capital on 9 January.
The explosion happened in Toledo street. Footage on Twitter showed smoke coming from the six-story building, a number of wrecked cars, and debris strewn in the road.
According to TVE, several people have been hurt, while Telemadrid is reporting that at least one person is trapped.
FA/PR