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For Gas Tankless Water Heaters, the cold water flows through a water pipe that runs through a chamber that is heated by the flames. For Electric Tankless Water Heaters the heating elements are actually immersed in the water.
Below is a diagram of how a Gas Tankless Water Heater (in this case a Bosch 1600H) works:
When you first turn on the hot water tap (say for the first shower of the day in the morning), the tankless water heater's internal pipes are full of cold water. It takes about three to five seconds for the first volume of newly heated water to flow out of the heater. From that point on the tankless water heater will generate an endless quantity of heated water.
This newly heated water must push the cold water slug that is sitting in the pipe run from the water heater to the point of use. Pushing this slug of water takes exactly the same time as it takes for a conventional tanked heater to provide the first quantity of hot water.
The net difference is that it will take three to five seconds longer for the hot water to reach your shower. Once the hot water starts flowing, you have access to an endless supply of hot water. This means that your family can take consecutive back-to-back showers without worrying about running out of hot water!