I would say that they were going fisticuffs before they whipped out the illusions. They were fighting very much the same way Tsuna fights his battles: head on. So indeed, the flashy display of flames gushing out of the building was most likely this hand-to-hand combat we are given before they "get serious." This is further evidenced by the fact that they've clashed staffs, which means they've been taking heavy whacks at one another! :)
Confused that in the previous chapter their powers were shown shooting out of the the building. If they're fighting pretty much all mind games, how did they start causing physical damage to the area?